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A Solution to Two Paradoxes of International Capital Flows

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  • Shang-Jin Wei
  • Jiandong Ju

Abstract

International capital flows from rich to poor countries can be regarded as either too low (the Lucas paradox in a one-sector model) or too high (when compared with the logic of factor price equalization in a two-sector model). To resolve the paradoxes, we introduce a non-neoclassical model which features financial contracts and firm heterogeneity. In our model, free patterns of gross capital flow emerge as a function of the quality of the financial system and the level of protection for property rights(i.e., the risk of expropriation. A poor country with an inefficient financial system but a low expropriation risk may simultaneously experience an outflow of financial capital but an inflow of foreign direct investment (FDI), resulting in a small net flow.

Suggested Citation

  • Shang-Jin Wei & Jiandong Ju, 2006. "A Solution to Two Paradoxes of International Capital Flows," IMF Working Papers 06/178, International Monetary Fund.
  • Handle: RePEc:imf:imfwpa:06/178
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    References listed on IDEAS

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    Keywords

    Economic models; Capital flows; Prices; Trade; Lucas paradox; factor price equalization; financial development; property rights institutions; and expropriation risk; capital flow; financial system; international capital; financial capital; International Factor Movements And International Business;

    JEL classification:

    • F11 - International Economics - - Trade - - - Neoclassical Models of Trade
    • F21 - International Economics - - International Factor Movements and International Business - - - International Investment; Long-Term Capital Movements
    • F33 - International Economics - - International Finance - - - International Monetary Arrangements and Institutions

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