International Capital Flows and World Production Efficiency

We develop a tractable two-country overlapping-generations model with domestic financial frictions and show that cross-country differences in financial development explain three recent empirical patterns of international capital flows. In our model, domestic financial frictions create two distinct distortions on the interest rates and production efficiency in the less financially developed country. International capital flows help ameliorate the two distortions. Financial capital flows and foreign direct investment not only facilitate crosscountry resource reallocation, but also trigger within-country resource reallocation among individuals with different productivity. From the efficient perspective, world output in the steady state is strictly higher under full capital mobility than under international financial autarky. However, if either financial capital flows or foreign direct investment is restricted, the world output may be lower. JEL Classification: E44, F41