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International Capital Flows in the Model with Limited Commitment and Incomplete Markets

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  • 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 empirical patterns of international capital flows between developed and developing countries in the past two decades. This paper integrates these two frictions into a two-country overlapping-generations framework to facilitate a direct comparison of their respective 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. Copyright Springer Science+Business Media New York 2014

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  • Jürgen von Hagen & Haiping Zhang, 2014. "International Capital Flows in the Model with Limited Commitment and Incomplete Markets," Open Economies Review, Springer, vol. 25(1), pages 195-224, February.
    • Handle: RePEc:kap:openec:v:25:y:2014:i:1:p:195-224
    DOI: 10.1007/s11079-013-9303-7
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    More about this item

    Keywords

    Financial development; Financial frictions; Foreign direct investment; Incomplete markets; Limited commitment; International capital flows; E44; F41;
    All these keywords.

    JEL classification:

    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
    • F41 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - Open Economy Macroeconomics

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