Working Paper: CEPR ID: DP5981
Authors: Jiandong Ju; Shangjin Wei
Abstract: International capital flows from rich to poor countries can be regarded as either too small (the Lucas paradox in a one-sector model) or too large (when compared with the logic of factor price equalization in a two-sector model). To resolve the paradoxes, we introduce a non-neo-classical model which features financial contracts and firm heterogeneity. In our model, free trade in goods does not imply equal returns to capital across countries. In addition, rich patterns of gross capital flows emerge as a function of financial and property rights institutions. A poor country with an inefficient financial system may simultaneously experience an outflow of financial capital but an inflow of FDI, resulting in a small net flow. In comparison, a country with a low capital-to-labor ratio but a high risk of expropriation may experience outflow of financial capital without compensating inflow of FDI.
Keywords: capital; bypass; circulation; expropriation risk; financial development; gross capital flow; heterogeneous entrepreneurs
JEL Codes: F11; F21; F33
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| expected returns (G17) | actual capital flows (F32) |
| poor financial system (P34) | capital outflows (F32) |
| poor financial system (P34) | FDI inflows (F21) |
| high expropriation risk (H13) | financial capital outflows (F21) |
| financial development (O16) | capital flows (F32) |
| factor endowments (D29) | interest rate (E43) |
| institutional quality (L15) | interest rate (E43) |