Non-traded goods, factor markets frictions, and international capital flows

The canonical one-sector model over predicts international capital flows by a factor of ten. We show that introducing a non-traded goods sector can reconcile the differences between the theoretical predictions and the observed flows. We analyze the quantitative impact of the nontraded sector using a calibrated model of a small open economy, in which non-traded goods are used in consumption and investment, and need capital and labor to be produced. The model features international frictions directly affecting international borrowing and lending, as well as domestic frictions that limit the scope of inter-sectoral reallocation of capital and labor. We find that: (1) the impact of domestic frictions on the size of international capital flows is similar to the impact of international frictions, and (2) the median elasticity of capital flows with respect to international frictions in the two-sector model with costly inter-sectoral reallocation is about 50-60% lower than that same elasticity in the one-sector model.