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Two-Way Capital Flows and Global Imbalances: A Neoclassical Approach

FRB of St. Louis Working Paper No. 2012-016A

55 Pages Posted: 21 Jun 2012  

Yi Wen

Federal Reserve Bank of St. Louis - Research Department; Tsinghua University

Pengfei Wang

HKUST, Department of Economics; Hong Kong University of Science & Technology (HKUST) - Department of Economics

Zhiwei Xu

Hong Kong University of Science & Technology (HKUST)

Date Written: June 20, 2012

Abstract

Financial capital and fixed capital tend to flow in opposite directions between poor and rich countries. Why? What are the implications of such two-way capital flows for global trade imbalances and welfare in the long run? This paper introduces frictions into a standard two-country neoclassical growth model to explain the pattern of two-way capital flows between emerging economies (such as China) and the developed world (such as the United States). We show how underdeveloped credit markets in China can lead to abnormally high rate of returns to fixed capital but excessively low rate of returns to financial capital relative to the U.S., hence driving out household savings (financial capital) on the one hand while simultaneously attracting foreign direct investment (FDI) on the other. When calibrated to match China’s high marginal product of capital and low real interest rate, the model is able to account for the observed rising trends of China’s …financial capital outflows and FDI inflows as well as its massive trade imbalances. Despite double heterogeneity in households and firms and a less than 100% capital depreciation rate, our two-country model is analytically tractable with closed form solutions at the micro level, which permits exact aggregation by the law of large numbers, so the general equilibrium of the model can be solved by standard log-linearization or higher order perturbation methods without the need of using numerical computation methods. Our model yield, among other things, three implications that stand in sharp contrast with the existing literature: (i) Global trade imbalances between emerging economies and the developed world are sustainable even in the steady state. (ii) There exists an immiserization effect of FDI --- namely, FDI is beneficial for the sourcing country but harmful to the recipient country under financial frictions. (iii) Our quantitative results cast doubts on the conventional wisdom that the "saving glut" of emerging economies is responsible for the low world interest rate.

Keywords: Allocation Puzzle, Saving Glut, Immiserization Effect of FDI, Global Imbalances, Two-Way Capital Flows, Welfare

JEL Classification: E21, E22, E44, F21, F32, F34, F41

Suggested Citation

Wen, Yi and Wang, Pengfei and Xu, Zhiwei, Two-Way Capital Flows and Global Imbalances: A Neoclassical Approach (June 20, 2012). FRB of St. Louis Working Paper No. 2012-016A. Available at SSRN: https://ssrn.com/abstract=2088429 or http://dx.doi.org/10.2139/ssrn.2088429

Yi Wen (Contact Author)

Federal Reserve Bank of St. Louis - Research Department ( email )

411 Locust St
Saint Louis, MO 63011
United States
314-444-8559 (Phone)
314-444-8731 (Fax)

Tsinghua University ( email )

Beijing, 100084
China

Pengfei Wang

HKUST, Department of Economics ( email )

Clearwater Bay
Kowloon, 999999
Hong Kong

Hong Kong University of Science & Technology (HKUST) - Department of Economics ( email )

Clear Water Bay
Kowloon, Hong Kong
China

Zhiwei Xu

Hong Kong University of Science & Technology (HKUST) ( email )

999999

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