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We develop a two-country overlapping-generations model with domestic financial frictions and show that cross-country differences in financial development explain three recent patterns of international capital flows. In our model, domestic financial frictions distort the interest rates and production efficiency in the less financially developed country. Capital flows not only lead to cross-country resource reallocation, but also trigger within-country resource reallocation among firms. From the efficiency perspective, full capital mobility raises the world output higher than under international financial autarky. If the mobility of either financial capital or foreign direct investment is restricted, the world output may be lower.


Capital account liberalization, financial frictions, financial development, foreign direct investment, world output gains


International Economics

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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.