DP5981 A Solution to Two Paradoxes of International Capital Flows

Author(s): Jiandong Ju , Shang-Jin Wei

Publication Date: December 2006

Keyword(s): capital bypass circulation , expropriation risk , gross capital flow , heterogeneous entrepreneurs , financial development

JEL(s): F11 , F21 , F33

Programme Areas: Development Economics , International Trade and Regional Economics

Link to this Page: www.cepr.org/pubs/dps/DP5981.asp.asp

International capital flows from rich to poor countries can be regarded as either too small (the Lucas paradox in a one-sector model) or too large (when compared with the logic of factor price equalization in a two-sector model). To resolve the paradoxes, we introduce a non-neo-classical model which features financial contracts and firm heterogeneity. In our model, free trade in goods does not imply equal returns to capital across countries. In addition, rich patterns of gross capital flows emerge as a function of financial and property rights institutions. A poor country with an inefficient financial system may simultaneously experience an outflow of financial capital but an inflow of FDI, resulting in a small net flow. In comparison, a country with a low capital-to-labor ratio but a high risk of expropriation may experience outflow of financial capital without compensating inflow of FDI.