Entry Costs , Intermediation , and Capital Flows ¤

In this paper, we reexamine the question “Why doesn’t capital ‡ow from rich to poor countries?” posed, most recently, by Lucas (1990). We build a simple contracting framework where costly intermediation together with an adverse selection problem have quantitatively important e¤ects on capital ‡ows. 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 di¤erences across countries gives rise to a rich variation of returns, one that suggests a tendency for capital to ‡ow 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 out‡ow from a poor country that removes capital controls and becomes open. We ...nd 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. ¤Finance and Business Economics, Marshall School of Business, HOH 701, USC, Los Angeles, CA 900891427. e-mail: [email protected], [email protected]. We are grateful to Matthias Doepke, Charles Engel, Doug Joines, Robert Lucas, Aris Protopapadakis, Jan Zabojnik and participants at various seminars for helpful comments. Fanghui Song provided excellent research assistance. An earlier version of this paper circulated under the title, “Capital Flows.”