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Financial Development and International Capital Flows

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Author Info
Haiping Zhang () (School of Economics, Singapore Management University)
Jurgen von Hagen () (Institut für Internationale Wirtschaftspolitik, University of Bonn)

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Abstract

We develop a general equilibrium model with financial frictions in which internal capital (equity capital) and external capital (bank loans) have di erent 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.

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Publisher Info
Paper provided by Singapore Management University, School of Economics in its series Working Papers with number 16-2007.

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Length: 30 pages
Date of creation: Sep 2007
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Publication status: Published in SMU Economics and Statistics Working Paper Series
Handle: RePEc:siu:wpaper:16-2007

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Related research
Keywords: Capital account liberalization; Capital controls; Financial frictions; Foreign direct investment; Internal capital; External capital;

Find related papers by JEL classification:
E32 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Business Fluctuations; Cycles
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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References listed on IDEAS
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  8. 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. [Downloadable!] (restricted)
  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 Journals, vol. 30(3), pages 513-532, September. [Downloadable!] (restricted)
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