Capital inflows, sustained investment surges and the role of external economies of scale in a developing economy

Standard open economy macro models with unemployment predict a contractionary short-run effect of international capital inflows. Empirical evidence, moreover, often associates such inflows with short-term booms and developing country policy makers frequently go out of their way to welcome foreign capital. Employing a portfolio balance framework, this paper distinguishes between international financial (i.e., bond) and "real" (i.e., equity) flows to explore the different consequences for capital accumulation that may follow over the medium-run. The presence of external economies of scale generates multiple equilibria and different kinds of capital flows may push investment in one direction or the other for sustained periods of time.