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Public investment in developing countries: A blessing or a curse?

► There is on average a negative effect of public investment on private investment. ► This result is reversed in countries that have good institutions, open to trade and financtrade and financial flows. ► Public policies should focus on the quality of public investment and the selection, evalution a...

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Published in:Journal of Comparative Economics 2011-03, Vol.39 (1), p.65-81
Main Authors: Cavallo, Eduardo, Daude, Christian
Format: Article
Language:English
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Summary:► There is on average a negative effect of public investment on private investment. ► This result is reversed in countries that have good institutions, open to trade and financtrade and financial flows. ► Public policies should focus on the quality of public investment and the selection, evalution and monitoring of investments, rather than just quantitative targets. This paper analyzes the relationship between public and private investment in developing countries. We set up a simple theoretical model where two countervailing forces coexist. On the one hand, public investment raises the marginal productivity of private capital and leads to potential crowding-in of private investment. On the other hand, weak institutions and restricted access to financing could diminish the positive effects of public investment projects and crowd-out private investment. The empirical results – which exploit both the time series and cross sectional variation in the data using a panel of 116 developing countries with annual observations between 1980 and 2006 – suggest that on average the crowing-out effect dominates. Moreover, we find that this crowing-out effect is dampened (or even reversed) in countries with better institutions – where the marginal productivity of public investment is conceivably higher – and that are more open to international trade and financial flows, such that financing constraints are less binding.
ISSN:0147-5967
1095-7227
DOI:10.1016/j.jce.2010.10.001