In a small open economy, financial frictions in the tradable sector justify a policy intervention which in the short run reduces wages and increases the supply of labor to this sector. Such a policy leads to faster entrepreneurial wealth accumulation, and less resource misallocation and higher productivity in the future. This policy is more desirable the smaller is the relative capitalization of entrepreneurs and the greater is the extent of misallocation in the tradable sector, both of which are likely to be more acute in developing countries. The constrained-optimal policy shifts labor supply towards the tradable sector away from leisure, home production and non-tradables. In the absence of suitable policy tools, a second-best policy is to tax consumption today in favor of future consumption, for example by means of official reserve accumulation under a closed capital account. Both constrained-optimal and second-best policies result in the temporary depreciation of the real exchange rate. Furthermore, we show that the intervention is more desirable in response to exogenous catch-up productivity growth (e.g., as in Asia) or to temporary competitiveness loss in the tradable sector (e.g., as in Spain). Thus, we provide a rationale for industrial and exchange rate policy interventions both for developing countries and in response to cyclical fluctuations in the developed countries.
