Why does capital flow out of countries with fast-growing productivity? In this paper, we provide a quantitative framework incorporating heterogeneous production units and underdeveloped domestic financial markets to study the joint dynamics of total factor productivity (TFP) and capital flows. When an unexpected once-and-for-all reform eliminates non-financial idiosyncratic distortions and liberalizes capital accounts, the TFP of our model economy rises gradually and capital flows out of it.

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... rise in TFP reflects efficient reallocation of capital and talent, a gradual process drawn out by domestic financial market frictions. The concurrent capital outflows are driven by the positive response of domestic saving to higher returns and by the sluggish response of domestic investment to higher TFP-the latter being another ramification of domestic financial frictions. We use our model to analyze the welfare consequences of opening up capital accounts. We find that the marginal welfare impact of capital account liberalization is negative for workers while it is positive for entrepreneurs and wealthy individuals.