Working Paper: CEPR ID: DP7690
Authors: Jürgen von Hagen; Haiping Zhang
Abstract: We develop a tractable, two-country, overlapping-generations model and show that cross-country differences in financial development can explain three recent empirical patterns of international capital flows: Financial capital flows from relatively poor to relatively rich countries while foreign direct investment flows in the opposite direction; net capital flows go from poor to rich countries; despite its negative net international investment position, the US receives a positive net international investment income. We also explore the welfare and distributional effects of international capital flows and show that the direction of capital flows may change along the convergence process of a developing country.Matsuyama (Econometrica 2004) argues that, in the presence of credit market imperfections, financial market globalization may lead to a steady-state equilibrium in which fundamentally identical countries end up with different levels of per-capita output. We show that this symmetry-breaking property depends crucially on the assumption that investment operates on the extensive rather than the intensive margin.
Keywords: capital account liberalization; financial development; financial frictions; foreign direct investment; symmetry breaking
JEL Codes: E44; F41
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| differences in financial development (O16) | distinct patterns of international capital flows (F32) |
| financial capital flows from poorer to richer countries (F21) | distinct patterns of international capital flows (F32) |
| FDI flows from richer to poorer countries (F21) | distinct patterns of international capital flows (F32) |
| financial frictions (G19) | equity premium (G12) |
| financial frictions (G19) | distort interest rates (E43) |
| financial development (O16) | higher rates of return on investments (G11) |
| credit contracts enforcement (K12) | higher borrowing capacity (G51) |
| transition process of developing country (O10) | change in direction of capital flows (F32) |
| capital account liberalization (F32) | accelerate capital accumulation (E22) |
| capital account liberalization (F32) | lower output level in the long run if not accompanied by financial development (O49) |
| differences in financial development (O16) | patterns of capital flows (F32) |