Publication Type

Journal Article

Publication Date

2007

Abstract

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.

Keywords

Capital account liberalization; Financial frictions; Interest-elastic saving

Discipline

Economics

Research Areas

Macroeconomics

Publication

Journal of Development Economics

Volume

106

First Page

66

Last Page

77

ISSN

0304-3878

Publisher

Elsevier

Creative Commons License

Creative Commons Attribution-Noncommercial-No Derivative Works 4.0 License
This work is licensed under a Creative Commons Attribution-Noncommercial-No Derivative Works 4.0 License.

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Economics Commons

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