DP8750 International Capital Flows with Limited Commitment and Incomplete Markets

Author(s): J├╝rgen von Hagen, Haiping Zhang
Publication Date: January 2012
Keyword(s): financial development, financial frictions, foreign direct investment, international capital flows, limited commitment
JEL(s): E44, F41
Programme Areas: International Macroeconomics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=8750

Recent literature has proposed two alternative types of financial frictions, i.e., limited commitment and incomplete markets, to explain the patterns of international capital flows between developed and developing countries observed in the past two decades. This paper integrates both types of frictions into a two-country overlapping-generations framework to facilitate a direct comparison of their 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.