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Intermediation Costs and Capital Flows

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  • Ayse Imrohoroglu

    (University of Southern California)

  • Krishna B. Kumar

    (University of Southern California)

Abstract

In this paper, we modify the standard neoclassical model by incorporating financial intermediation in order to deliver returns consistent with the observation that capital primarily flows to middle income countries. We build a static contracting framework where costly intermediation together with an adverse selection problem have quantitatively important effects on capital flows. When intermediation costs are ignored, the model behaves like the neoclassical model in terms of capital returns. However, when intermediation costs are considered, returns to capital in middle income countries could exceed those in poor and rich countries high costs of intermediation cause poor countries to concentrate their investments in projects with low returns, while the standard neoclassical effect lowers returns in capital-rich countries. When we embed the return function from the static analysis in a two-country dynamic model, there is capital outflow from a poor country that removes capital controls and becomes open. Even though the closed economy dominates in terms of capital employed in production, it is the open economy that dominates in terms of income, consumption and welfare. (Copyright: Elsevier)

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Bibliographic Info

Article provided by Elsevier for the Society for Economic Dynamics in its journal Review of Economic Dynamics.

Volume (Year): 7 (2004)
Issue (Month): 3 (July)
Pages: 586-612

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Handle: RePEc:red:issued:v:7:y:2004:i:3:p:586-612

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References

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  1. Thorsten Beck & Ross Levine & Norman Loayza, 1999. "Financial Intermediation and Growth: Causality and Causes," Working Papers Central Bank of Chile 56, Central Bank of Chile.
  2. Chang-Tai Hsieh & Peter J. Klenow, 2007. "Relative Prices and Relative Prosperity," American Economic Review, American Economic Association, vol. 97(3), pages 562-585, June.
  3. Simeon Djankov & Rafael La Porta & Florencio LopezdeSilanes & Andrei Shleifer, 2000. "The Regulation of Entry," NBER Working Papers 7892, National Bureau of Economic Research, Inc.
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  6. Greenwood, J. & Jovanovic, B., 1990. "Financial Development, Growth, And The Distribution Of Income," University of Western Ontario, The Centre for the Study of International Economic Relations Working Papers 9002, University of Western Ontario, The Centre for the Study of International Economic Relations.
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  8. Edward C. Prescott, 1997. "Needed: a theory of total factor productivity," Staff Report 242, Federal Reserve Bank of Minneapolis.
  9. Douglas Gollin, 2001. "Getting Income Shares Right," Department of Economics Working Papers 2001-11, Department of Economics, Williams College.
  10. Martin Neil Baily & Robert M. Solow, 2001. "International Productivity Comparisons Built from the Firm Level," Journal of Economic Perspectives, American Economic Association, vol. 15(3), pages 151-172, Summer.
  11. Andrés Erosa, 2000. "Financial Intermediation and Occupational Choice in Development," UWO Department of Economics Working Papers 20003, University of Western Ontario, Department of Economics.
  12. Harm Zebregs, 1998. "Can the Neoclassical Model Explain the Distribution of Foreign Direct Investment Across Developing Countries?," IMF Working Papers 98/139, International Monetary Fund.
  13. Lucas, Robert E, Jr, 1990. "Why Doesn't Capital Flow from Rich to Poor Countries?," American Economic Review, American Economic Association, vol. 80(2), pages 92-96, May.
  14. Kumar, Krishna B., 2003. "Education And Technology Adoption In A Small Open Economy: Theory And Evidence," Macroeconomic Dynamics, Cambridge University Press, vol. 7(04), pages 586-617, September.
  15. Beck, T.H.L. & Demirgüç-Kunt, A. & Levine, R., 2000. "A new database on financial development and structure," Open Access publications from Tilburg University urn:nbn:nl:ui:12-3125518, Tilburg University.
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Cited by:
  1. Laura Alfaro & Areendam Chanda & Sebnem Kalemli-Ozcan & Selin Sayek, 2006. "How Does Foreign Direct Investment Promote Economic Growth? Exploring the Effects of Financial Markets on Linkages," NBER Working Papers 12522, National Bureau of Economic Research, Inc.
  2. Fidel Pérez Sebastián & Lilia Maliar & Serguei Maliar, 2005. "Sovereign Risk, Fdi Spillovers, And Economic Growth," Working Papers. Serie AD 2005-27, Instituto Valenciano de Investigaciones Económicas, S.A. (Ivie).
  3. Meza, Felipe & Benjamin, David, 2006. "Productivity in economies with financial frictions: facts and a theory," Discussion Paper Series In Economics And Econometrics 0613, Economics Division, School of Social Sciences, University of Southampton.
  4. Silva, André C., 2010. "Managerial ability and capital flows," Journal of Development Economics, Elsevier, vol. 93(1), pages 126-136, September.

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