Financial Development and the Patterns of International Capital Flows ∗

We develop a tractable two-country overlapping generations model and show analytically that the cross-country differences in financial development help explain three recent empirical facts characterizing international capital flows: financial capital flows from relatively poor to relatively rich countries while FDI flows in the opposite direction; net capital flows are from poor to rich countries; despite of its negative net positions on international investment, the United States receives a positive net investment income. We also show that how the patterns of capital flows may reverse along the growth path of a developing country. According to Matsuyama (Econometrica, 2004), in the presence of credit market imperfections, financial market globalization may lead to a steady-state equilibrium in which fundamentally identical countries end up with different levels of per capita output. We show that this symmetry-breaking property depends crucially on the assumption of the fixed investment size of entrepreneurial projects. JEL Classification: E44, F41