On the Perverse Effect of Capital Account Liberalization: The Role of Labor Market Rigidity

We propose a new explanation for why developing countries may fail to benefit from financial globalization based on the role of local labor market institutions. In our model, the combination of a rigid labor market and low economy-wide productivity generates a low domestic interest rate under financial autarky. In such economies, financial openness discourages capital inflows and leads to a worsening of the domestic unemployment rate. In contrast, in either a developing country with a flexible labor market or a developed country, financial opening generally leads to higher employment. These predictions are broadly consistent with the empirical patterns observed in the data.