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International Capital Flows with Limited Commitment and Incomplete Markets

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  • Jurgen von Hagen

    ()
    (University of Bonn, Indiana University and CEPR. Lennestrasse. 37, D-53113 Bonn, Germany.)

  • Haiping Zhang

    ()
    (School of Economics, Singapore Management Unversity)

Abstract

Recent literature has proposed two alternative types of financial frictions, i.e., limited commitment and incomplete markets, to explain the patterns of international capital flows between developed and developing countries observed in the past two decades. This paper integrates both types of frictions into a two-country overlapping-generations framework to facilitate a direct comparison of their e ects. 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 eciency, and aggregate output.

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Bibliographic Info

Paper provided by Singapore Management University, School of Economics in its series Working Papers with number 17-2011.

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Length: 31 pages
Date of creation: Dec 2011
Date of revision:
Publication status: Published in SMU Economics and Statistics Working Paper Series
Handle: RePEc:siu:wpaper:17-2011

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Keywords: financial development; financial frictions; foreign direct investment; incomplete markets; limited commitment; international capital flows;

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  1. Carroll, Christopher D & Jeanne, Olivier, 2009. "A Tractable Model of Precautionary Reserves, Net Foreign Assets, or Sovereign Wealth Funds," CEPR Discussion Papers 7449, C.E.P.R. Discussion Papers.
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  8. A.L. Keith Acheson, 2010. "Globalization," Carleton Economic Papers 10-01, Carleton University, Department of Economics.
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  11. Damiano Sandri, 2010. "Growth and Capital Flows with Risky Entrepreneurship," IMF Working Papers 10/37, International Monetary Fund.
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