We develop a general equilibrium model with nancial frictions in which internal capital (equity capital) and external capital (bank loans) have di erent rates of return. Financial development raises the rate of return on external capital but has a non-monotonic e ect on the rate of return on internal capital. We then show in a two-country model that capital account liberalization leads to out ow of nancial capital from the country with less developed nancial system. However, the direction of foreign direct investment (FDI, henceforth) depends on the exact degrees of nancial development in the two countries as well as the speci c capital controls policy. Our model helps explain the Lucas Paradox (Lucas, 1990). Countries with least developed nancial system have the out ows of both nancial capital and FDI; countries with most developed nancial system witness two-way capital ows, i.e., the in ow of nancial capital and the out ow of FDI; countries with intermediate level of nancial development have the out ow of nancial capital and the in ow of FDI. It is consistent with the fact that FDI ows not to the poorest countries but to the middle-income countries.
Capital account liberalization; Financial frictions; Interest-elastic saving
Journal of Development Economics
ZHANG, Haiping and von Hagen, Jürgen.
Financial Development and International Capital Flows. (2007). Journal of Development Economics. 106, 66-77. Research Collection School Of Economics.
Available at: http://ink.library.smu.edu.sg/soe_research/1025
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