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Financial Development and International Capital Flows

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  • Jurgen von Hagen

    (SMU)

  • Haiping Zhang

Abstract

We develop a general equilibrium model with nancial frictions in which internal capital (equity capital) and external capital (bank loans) have different 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 outflow 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 outows of both financial capital and FDI;countries with most developed financial system witness two-way capital ows, i.e., the inflow of financial capital and the outow of FDI; countries with intermediate level of financial development have the outow of financial capital and the inflow of FDI. It is consistent with the fact that FDI ows not to the poorest countries but to the middle-income countries.

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Bibliographic Info

Paper provided by East Asian Bureau of Economic Research in its series Macroeconomics Working Papers with number 22434.

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Date of creation: Jan 2007
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Handle: RePEc:eab:macroe:22434

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Keywords: Capital account liberalization; capital controls; financial frictions; foreign direct investment; Internal capital; External capital;

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  1. Jürgen von Hagen & Haiping Zhang, 2006. "Financial Liberalization in a Small Open Economy," CESifo Working Paper Series 1771, CESifo Group Munich.
  2. Simeon Djankov & Oliver Hart & Caralee McLiesh & Andrei Shleifer, 2006. "Debt Enforcement Around the World," NBER Working Papers 12807, National Bureau of Economic Research, Inc.
  3. Bengt Holmstrom & Jean Tirole, 1994. "Financial Intermediation, Loanable Funds and the Real Sector," Working papers 95-1, Massachusetts Institute of Technology (MIT), Department of Economics.
  4. Rafael La Porta & Florencio Lopez-de-Silane & Andrei Shleifer & Robert W. Vishny, 1996. "Law and Finance," NBER Working Papers 5661, National Bureau of Economic Research, Inc.
  5. Jiandong Ju & Shang-Jin Wei, 2006. "A Solution to Two Paradoxes of International Capital Flows," NBER Working Papers 12668, National Bureau of Economic Research, Inc.
  6. Pol Antràs & Ricardo J. Caballero, 2009. "Trade and Capital Flows: A Financial Frictions Perspective," Journal of Political Economy, University of Chicago Press, University of Chicago Press, vol. 117(4), pages 701-744, 08.
  7. von Hagen, Jürgen & Zhang, Haiping, 2006. "A welfare analysis of capital account liberalization," ZEI Working Papers B 01-2006, ZEI - Center for European Integration Studies, University of Bonn.
  8. Caprio,Gerard & Honohan,Patrick & Stiglitz,Joseph E. (ed.), 2006. "Financial Liberalization," Cambridge Books, Cambridge University Press, Cambridge University Press, number 9780521030991.
  9. Steven Globerman & Daniel M Shapiro, 1999. "The Impact of Government Policies on Foreign Direct Investment: The Canadian Experience," Journal of International Business Studies, Palgrave Macmillan, vol. 30(3), pages 513-532, September.
  10. Robert Townsend, 1979. "Optimal contracts and competitive markets with costly state verification," Staff Report, Federal Reserve Bank of Minneapolis 45, Federal Reserve Bank of Minneapolis.
  11. Diamond, Douglas W, 1984. "Financial Intermediation and Delegated Monitoring," Review of Economic Studies, Wiley Blackwell, Wiley Blackwell, vol. 51(3), pages 393-414, July.
  12. Kiminori Matsuyama, 2008. "Aggregate Implications of Credit Market Imperfections," NBER Chapters, in: NBER Macroeconomics Annual 2007, Volume 22, pages 1-60 National Bureau of Economic Research, Inc.
  13. Kiminori Matsuyama, 2007. "Credit Traps and Credit Cycles," American Economic Review, American Economic Association, American Economic Association, vol. 97(1), pages 503-516, March.
  14. Lucas, Robert E, Jr, 1990. "Why Doesn't Capital Flow from Rich to Poor Countries?," American Economic Review, American Economic Association, American Economic Association, vol. 80(2), pages 92-96, May.
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