Financial Development and International Capital Flows

We develop a general equilibrium model with financial frictions in which equity and credit have different rates of return. Financial development raises the loan rate but has a non-monotonic effect on the equity return. We then show in a two-country model that capital account liberalization leads to outflow of financial capital from the country with less developed financial system. However, the direction of foreign direct investment (FDI, henceforth) depends on the exact degrees of financial development in the two countries as well as the specific capital controls policy. Our model helps explain the Lucas Paradox (Lucas, 1990). Countries with least developed financial system have the outflows of both financial capital and FDI; countries with most developed financial system witness two-way capital flows, i.e., the inflow of financial capital and the outflow of FDI; countries with intermediate level of financial development have the outflow of financial capital and the inflow of FDI. It is consistent with the fact that FDI flows not to the poorest countries but to the middle-income countries. JEL Classification: E44, F41