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Capital Inflows and Investment

Barbara Pels
Institute for International Integration Studies and Department of Economics Trinity College Dublin

IIIS Discussion Paper No. 330


According to neoclassical economic theory capital scarce countries with an open capital account will attract foreign capital because the rate of return in these countries is high. Capital inflows will be channelled towards investment projects in order to reap the benefi ts of the higher rate of return, and this will lead to economic growth. Empirically it is not clear that this mechanism is at work. This paper extends the current literature by combining the insight that domestic nance matters for growth into the empirical literature on the effects of capital inflows. A panel of 39 countries between 1976 and 2003 is used to estimate the e ects of capital inflows on xed investment. I use panel data on 39 developing countries between 1976 and 2003 to show that the eff ect of capital inflows on physical investment depends on the type of infl ow and on the level of domestic nancial development. It is shown that the efect of capital inflows on physical investment depends on the type of inflow and on the level of domestic nancial development. The e ects of aggregate capital inflows on investment are positive, small and increasing with the level of domestic nancial development. Only for debt inflows there is an indicatiThe key result of the so-called “New Trade Theory” is that countries gain from falling trade costs by an increase in the number of varieties available to consumers. Though the number of varieties in a given country rises, it is also true that global variety decreases from increased competition wherein imported varieties drive out some local varieties. This second result is a major issue for anti-trade activists who criticize the move towards free trade as promoting “homogenization” or Americanization” of varieties across countries. We present a model of endogenous entry with heterogeneous firms which models this concern in two ways: a portion of a consumer’s income is spent overseas (i.e. tourism) and an existence value (a common tool in environmental economics where simply knowing that a species exists provides utility). Since lowering trade costs induces additional varieties to export and drives out some non-exported varieties, these modifications result in welfare losses not accounted for in the existing literature. Nevertheless, it is only through the existence value that welfare can fall as a result of declining trade barriers. Thus, for these criticisms of globalization to dominate, it must be that this loss in the existence value outweighs the direct benefits from consumption.


Last updated 28 August 2014 by IIIS (Email).