International Capital Flows with Limited Commitment and Incomplete Markets

32 Pages Posted: 20 Jan 2012

See all articles by Jürgen von Hagen

Jürgen von Hagen

University of Bonn - Institute of Economic Policy; Centre for Economic Policy Research (CEPR)

Haiping Zhang

affiliation not provided to SSRN

Date Written: January 2012

Abstract

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.

Keywords: financial development, financial frictions, foreign direct investment, international capital flows, limited commitment

JEL Classification: E44, F41

Suggested Citation

von Hagen, Jürgen and Zhang, Haiping, International Capital Flows with Limited Commitment and Incomplete Markets (January 2012). CEPR Discussion Paper No. DP8750, Available at SSRN: https://ssrn.com/abstract=1988682

Jürgen Von Hagen (Contact Author)

University of Bonn - Institute of Economic Policy ( email )

Adenauerallee 24
D-53113 Bonn
Germany

Centre for Economic Policy Research (CEPR)

London
United Kingdom

Haiping Zhang

affiliation not provided to SSRN ( email )

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