Capital Flows

In this paper, we reexamine the question "Why doesn't capital flow from rich to poor countries?" posed by Lucas (1990). Our findings suggest that even if capital flows freely it will flow to middle income countries rather than to poor countries. We start with the stylized fact that poorer countries have high intermediation costs, and develop a simple disaggregation of the neoclassical production function based on a model of costly intermediation of funds between safe and risky projects when there is ex ante heterogeneity of project potential. When intermediation costs are ignored, the model behaves much like the neoclassical model in terms of capital returns. However, when intermediation costs are considered, the return for a given amount of capital can be non-monotonic in costs. Therefore, the combination of capital and cost differences across countries gives rise to a rich variation of returns, one that suggests a tendency for capital to flow to middle income countries, as seen in data. Indeed, when we embed the static return function in a two-country dynamic model, there is capital outflow from a poor country that removes capital controls and becomes open. We find that even though the closed economy dominates in terms of capital employed in production, it is the open economy that dominates in terms of income, consumption and welfare.