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Entry Costs, Intermediation, and Capital Flows

  • Ayse Imrohoroglu

    (University of Southern California)

  • Krishna B. Kumar

    (University of Southern California)

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.

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Length: 36 pages
Date of creation: 04 Apr 2003
Date of revision:
Handle: RePEc:wpa:wuwpma:0304001
Note: Type of Document - Acrobat PDF; prepared on IBM PC ; to print on HP PostScript; pages: 36; figures: included
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