Credit Market Imperfections and International Capital Market Flows
How will capital market imperfections, such as private information and costly state verification, affect international capital market flows between countries that are identical in every way but their initial capital stocks? To answer this question, we devise a dynamic infinite-horizon model with overlapping generations. Capital production is an increasing and concave function of the amount invested, but the realization of that investment is private information. All factors but financial capital are immobile, so that the net worth of capital producers is closely linked with the capital stock of the country. In a closed-economy, the capital stock of each country will converge to the same steady state. If financial capital is mobile and the initial capital stocks are different, the interest rates will be equalized but the level of investment will differ because of differences in net worth. Financial capital will typically flow from the wealthy to the poor country, but the countries will not converge to the same steady state and capital can, under some conditions, flow the "wrong way."
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