International Capital Flows in the Model with Limited Commitment and Incomplete Markets

Publication Type

Journal Article

Publication Date

2-2014

Abstract

Recent literature has proposed two alternative types of financial frictions, i.e., limited commitment and incomplete markets, to explain the empirical patterns of international capital flows between developed and developing countries in the past two decades. This paper integrates these two frictions into a two-country overlapping-generations framework to facilitate a direct comparison of their respective effects. In our model, limited commitment distorts the investment made by agents with different productivity, which creates a wedge between the interest rates on equity capital vs. credit capital; while incomplete markets distort the investment among projects with different riskiness, which creates a wedge between the risk-free rate and the mean rate of return to risky capital. We show that the two approaches are observationally equivalent with respect to their implications for international capital flows, production efficiency, and aggregate output.

Keywords

Financial development, Financial frictions, Foreign direct investment, Incomplete markets, Limited commitment, International capital flows

Discipline

International Economics

Research Areas

Macroeconomics

Publication

Open Economies Review

Volume

25

Issue

1

First Page

195

Last Page

224

ISSN

0923-7992

Identifier

10.1007/s11079-013-9303-7

Publisher

Springer Verlag

Additional URL

https://doi.org/10.1007/s11079-013-9303-7

Link to Full Text

Share

COinS