The Capital Matthew Effect: Directed Technical Change and International Capital Flows

Abstract

This study shows that technological specialization is the primary driver of long-term international capital flows. The underlying mechanism comprises the two faces of capital scarcity: although a shortage of capital currently generates a higher marginal product, it also makes a country inclined toward capital-saving technology. Therefore, in equilibrium, the rate of capital returns is jointly determined by a convergence effect from diminishing return and an opposing divergence effect from directed technological change. Initially capital-rich countries favor capital-complements-biased technology and continuously import capital from capital-poor countries that develop capital-substitutes-biased technology. We name this anti-convergence force on capital allocation the capital Matthew effect. This new perspective can help rationalize many related international finance puzzles, including the Lucas paradox, global imbalance, and allocation puzzle.

Keywords: directed technical change; international capital flows; Lucas puzzle; global imbalance; allocation puzzle; Matthew effect

JEL Classification: F20; F30; F63; G15; O33; P16