Optimal Development Policies with Financial Frictions∗ Oleg Itskhoki

We study optimal dynamic Ramsey policies in a standard growth model with finan-cial frictions. For developing countries with low financial wealth, the optimal policy intervention increases labor supply and lowers wages, resulting in higher entrepreneurial profits and faster wealth accumulation. This in turn relaxes borrowing constraints in the future, leading to higher labor productivity and wages. The use of additional policy instruments, such as subsidized credit, may be optimal as well. In the long run, the optimal policy reverses sign. Taking advantage of the tractability of our framework, we extend the model to study its implications for optimal exchange rate and sectoral industrial policies. ∗We are particularly grateful to Mike Golosov for many stimulating discussions. We also thank Ivá