https://macropaperwarehouse.com/authors/felipe-saffie/Felipe SaffieHugo -- gohugo.ioen-ushttps://macropaperwarehouse.com/papers/the-micro-and-macro-dynamics-of-capital-flows/https://macropaperwarehouse.com/papers/the-micro-and-macro-dynamics-of-capital-flows/<p>Using the 2001 Hungarian capital account liberalization as a quasi-natural experiment and census-level firm data covering the entire economy (1992–2008), the paper identifies two channels through which capital inflows affect resource allocation: an <strong>input-cost channel</strong> (lower cost of capital benefits capital-intensive sectors) and a <strong>consumption channel</strong> (higher household incomes benefit high-expenditure-elasticity sectors, chiefly services). The paper finds the consumption channel dominates: one standard deviation increase in expenditure elasticity is associated with 8.4% greater real value-added growth, versus 4.2% for one standard deviation in capital elasticity. Along the extensive margin, high-expenditure-elasticity sectors experience 15% higher net entry and 19% higher gross entry. A calibrated multi-sector heterogeneous-firm model with non-homothetic preferences (à la Comin–Lashkari–Mestieri 2021) replicates 12 non-targeted moments and reproduces 70% of the reallocation toward services observed in Hungary. Counterfactual exercises show that a neoclassical homothetic model underpredicts reallocation by a factor of ten and generates counterfactual real exchange rate depreciation. Despite reallocation toward less productive service firms (a negative composition effect), aggregate TFP increased 11.4% in Hungary — driven by a love-of-variety effect from entry (mass-of-firms effect of +3.5% versus composition effect of −1.9%). Non-homothetic preferences amplify this mechanism: capital-scarce economies experience 21.9% larger TFP gains than homothetic models predict.</p>