Paper No. 16-2007
We develop a general equilibrium model with nancial frictions in which internal capital (equity capital) and external capital (bank loans) have different rates of return. Financial development raises the rate of return on external capital but has a non-monotonic effect on the rate of return on internal capital. 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 outows of both financial capital and FDI;countries with most developed financial system witness two-way capital ows, i.e., the inflow of financial capital and the outow of FDI; countries with intermediate level of financial development have the outow of financial capital and the inflow of FDI. It is consistent with the fact that FDI ows not to the poorest countries but to the middle-income countries.