INTERNATIONAL CAPITAL FLOWS

International capital flow from rich to poor countries can be regarded as either too low (the Lucas paradox in a one-sector model) or too high (when compared with the logic of factor price equalization in a two-sector model). To resolve the paradoxes, we propose a non-neo-classical theory that marries a model of financial contract between entrepreneurs and investors due to Holmstrom and Tirole (1998) and the HeckscherOhlin-Samuelson framework. Return to financial investment and marginal product of physical capital are naturally separate. The model generates a number of interesting predictions that seem to fit the data well. For example, between rich and poor countries, there can be massive, two-way gross capital flows but a small net flow. In fact, in the unique equilibrium in the world capital market, the relatively inefficient financial system is completely bypassed. ∗University of Oklahoma, E-mail: jdju@ou.edu; **International Monetary Fund and NBER, E-mail: swei@imf.org, Web page: www.nber.org/∼wei.

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