Financial Development and International Capital Flows
Jurgen von Hagen
We develop a general equilibrium model with financial frictions in which internal capital (equity capital) and external capital (bank loans) have dierent rates of return. Financial development raises the rate of return on external capital but has a non-monotonic effect on the rate of return on internal capital. We then show in a two-country model that capital account liberalization leads to out
ow of financial capital from the country with less developed financial system. However, the direction of foreign direct investment (FDI, henceforth) depends on the exact degrees of financial development in the two countries as well as the specific capital controls policy. Our model helps explain the Lucas Paradox (Lucas, 1990). Countries with least developed financial system have the out
ows of both financial capital and FDI; countries with most developed financial system witness two-way capital fl
ows, i.e., the in
ow of financial capital and the out
ow of FDI; countries with intermediate level of financial development have the out
ow of financial capital and the in
ow of FDI. It is consistent with the fact that FDI
ows not to the poorest countries but to the middle-income countries.
Capital account liberalization, Capital controls, Financial frictions,Foreign direct investment, Internal capital, External capital
In order to set up a list of libraries that you have access to,
you must first login
or sign up.
Then set up a personal list of libraries from your profile page by
clicking on your user name at the top right of any screen.