A two-sector intertemporal optimizing model of capital accumulation and external indebtedness

Abstract

An intertemporal optimizing model for a small open economy is developed to study the dynamic interaction between capital accumulation and external indebtedness and the steady-state relation between the size of the capital stock and the level of external indebtedness. The analysis shows that in a context of growth, persistent current-account imbalances may result as the outcome of optimal behavior on the part of intertemporal maximizing agents. However, it is shown that by incurring external debt to partially finance its gro wth effort, the economy places itself on a constrained growth path that ultimately affects the optimal level of the steady-state capital stock.