This paper elaborates on Baldwin’s (1999) New Economic Geography model allowing
for capital accumulation and capital mobility between a “rich” and a “poor” region. A central
government decides upon the level and the regional and sectoral allocation of productivity enhancing
public investments. We derive results on how such policies affect the overall private capital stock and
its regional allocation under alternative financing schemes. We show that the regional and sectoral
distribution of public capital matters in determining the final impact of an increase in public capital on
the level of private capital. Furthermore, we find that increasing public capital in the “poor” region does
not always increase the share of manufacturing in that region as the final result depends on the relative
strength of two effects which have been studied separately in the literature so far: the “productivity” and
the “demand” effects. Finally, we show that in order to be effective regional policy must not confine itself to the expenditure side but has to take into account the financing side at the same time.
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