In this paper, we reexamine the question "Why doesn't capital flow from rich to poor countries?" posed, most recently, by Lucas (1990). We build a simple 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 much like the neoclassical model in terms of capital returns. However, when intermediation costs are considered, the return for a given amount of capital can be non-monotonic in costs. Therefore, the combination of capital and cost differences across countries gives rise to a rich variation of returns, one that suggests a tendency for capital to flow to middle income countries, as seen in data. Indeed, when we embed the static return function in a two-country dynamic model, there is capital outflow from a poor country that removes capital controls and becomes open. We find that 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.
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Paper provided by EconWPA in its series Macroeconomics with number
0304001.
Length: 36 pages Date of creation: 04 Apr 2003 Date of revision: Handle: RePEc:wpa:wuwpma:0304001
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Find related papers by JEL classification: E22 - Macroeconomics and Monetary Economics - - Macroeconomics: Consumption, Saving, Production, Employment, and Investment - - - Capital; Investment; Capacity F21 - International Economics - - International Factor Movements and International Business - - - International Investment; Long-Term Capital Movements G20 - Financial Economics - - Financial Institutions and Services - - - General
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Simeon Djankov & Rafael La Porta & Florencio LopezdeSilanes & Andrei Shleifer, 2000.
"The Regulation of Entry,"
NBER Working Papers
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Aart Kraay & Norman Loayza & Luis Serven & Jaume Ventura, 2000.
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NBER Working Papers
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[Downloadable!] (restricted)