Working Paper: CEPR ID: DP8750
Authors: Jürgen von Hagen; Haiping Zhang
Abstract: Recent literature has proposed two alternative types of financial frictions, i.e., limited commitment and incomplete markets, to explain the patterns of international capital flows between developed and developing countries observed in the past two decades. This paper integrates both types of frictions into a two-country overlapping-generations framework to facilitate a direct comparison of their effects. In our model, limited commitment distorts the investment made by agents with different productivity, which creates a wedge between the interest rates on equity capital vs. credit capital; while incomplete markets distort the investment among projects with different riskiness, which creates a wedge between the risk-free rate and the mean rate of return to risky capital. We show that the two approaches are observationally equivalent with respect to their implications for international capital flows, production efficiency, and aggregate output.
Keywords: Financial Development; Financial Frictions; Foreign Direct Investment; International Capital Flows; Limited Commitment
JEL Codes: E44; F41
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Limited commitment (D86) | Distortion in investment (F21) |
| Distortion in investment (F21) | Inefficient capital allocation (D61) |
| Limited commitment (D86) | Wedge between interest rates on equity and credit capital (G19) |
| Incomplete markets (D52) | Overinvestment in safe assets (E22) |
| Incomplete markets (D52) | Underinvestment in risky assets (G11) |
| Overinvestment in safe assets (E22) | Distortion in aggregate production efficiency (E23) |
| Underinvestment in risky assets (G11) | Distortion in aggregate production efficiency (E23) |
| Financial market distortions (G19) | Lower financial development (O16) |
| Lower financial development (O16) | Impact on capital flows and output levels (F32) |