BAHIR DAR UNIVERSITY

COLLAGE OF BUSINESS AND ECONOMICS

DEPARTMENT OF ECONOMICS

MSc PROGRAM IN ECONOMIC POLICY ANALYSIS

ADVANCED MACROECONOMICS II ASSIGNMENT-II

Critical Review on
Why Doesn't Capital Flow from Rich to Poor Countries ?

By:
1. Amare yalew
2. Belainew Belete
3. Gashaw Molla
4. Tesfa Askal
June,2015
Bahir Dar , Ethiopia
Outlines:
Objective:
 Introduction
 Summery
 Evaluation
 Conclusion
 Reference
1.1. Objectives
The objective of reviewing this article is
 To review the validity of neoclassical trade and growth
theory is valid.
Introduction
In this article review, we will discuss Lucas article on American
Economic Association.
 Lucas’s article is about directional flow Capital.
 In particular, he argue that the reason of the divergence of
neoclassical conventional theory of trade and growth is the failure
of conventional assumptions, in both market fundamentals,
international capital markets, and methods of measurement /
quantification of variables.
 After summarizing Lucas article’s main points, we shall be
declaring the strength and the main criticisms of the article.
Lastly, we shall show that the article review is organized in four
parts such as introduction, summery, evaluation, and conclusion.
 Summery
This section contains a summary of Why Doesn't
Capital Flow from Rich to Poor Countries.
Under neoclassical models of trade and growth, in
which countries face the same constant returns to
scale, homogenous capital and labor inputs, and
completely open world capital markets, capital would
flow from rich to poor countries because the marginal
product of capital would be higher in poorer economy.
summary cont…
Difference of production per worker between two
countries, with the same factors of production and
CRTS , is due to differentials of capital per worker.
Therefore, capital flows from rich to poorer countries
until capital-labor ratios, and hence wages and capital
returns, are equalized
The fact that immense capital flows from rich to poor
countries are not observed in practice, however,
signifies important flaws in the validity of
conventional classical assumptions.
 summary cont…
Evidence show that Western Hemisphere receives
substantial private direct investment and portfolio flows,
while poorest countries in Africa receive less than middle-
income emerging Asia, developed economies account for
the majority of worldwide foreign direct investment, that
equity inflows per capita (FDI and portfolio equity
investment) are substantially greater in rich than poor
countries which all contrasting with neoclassical
predictions.
Lucas then compares the United States and India in
1988,and concluding that the marginal product of capital in
India must be about 58 times that of the United States.
summary cont…
As a result this paper is aimed to answer the f.f two
questions
As indicated on the preface, the main aim of this article
was to
1. what assumptions of classical is wrong and
2.what assumption should replaced on classical
assumption?
To answer this central economic development
question he consider the following factors.
Summary cont…
Using a rough estimate of Denison’s 1962 comparison
of US productivity and then applying Kruger’s 1959
cross-country estimates of relative human capital
stocks, Lucas narrows the
predicted rate of return ratio between India and the
United States to near unity.
Generally, omission of factor of production (land,
human capital, etc.) which positively affects the
returns to capital, the conventional neoclassical
approach will misrepresent the implied capital flow.
1. Fundamentals:

A. Missing Factors of Production :

Human capital
The production function include human capital
The argument suggests that correcting for human capital
differentials reduces the predicted return ratios between very
rich and very poor countries from about 58 at least to about 5,
and possibly, if knowledge spillovers are local enough, to
unity.
Omission of factor of production (land, human capital, etc.)
positively affects the returns to capital, the conventional
neoclassical approach will misrepresent the implied capital
flow.
 B. Lower Total Factor Productivity :
Institutions
Conventionally, discrepancies in total factor productivity
are assumed to account for the Lucas paradox.
quality of institutions is one major contributor to total
factor productivity.
 Institutional weakness drives a wedge between expected
returns and ex-post returns – even if technology is readily
available to all countries, barriers to adoption or differences
in efficient use of the technology can dramatically alter the
return to capital.
 A study by Alfaro, et al revealed that institutional quality is
the leading causal variable explaining the Lucas Paradox.
 Cont…
The authors argue that deterioration in institutional
quality between rich and poor countries accounts for
the sharply divergent patterns of international capital
movements
2. Capital Market Imperfections
Capital Market Imperfections would be viewed as :

I. Costs of International Trade

• Although marginal productivity of capital determines
how much to invest, a firm chooses to their invest is
first placed by analyzing total profitability.
• profit is subject to costs of international trade (taxes,
capital controls, tariffs, transport costs, and other
barriers to trade.).
As a result , this barriers are the means to diverge flow of
capital based on productivity.
II. Home Bias (Information Asymmetry)
Due to asymmetric information, capital will not flow from
rich to poor countries, even if the expected return is higher.
This information asymmetries due to the poor quality and
low credibility of financial information and force
foreigners to have the strongest explanatory power in the
home bias phenomenon.
The regression results on FDI corroborate the results from
portfolio equity flows, indicating that corporate investors
prefer to invest in countries near to their home country, or
in countries within the same economic union or possessing
a similar legal system.
 cont…
Investors feel more optimistic and confident in
investing in more familiar countries due to the
informational advantage, despite potentially more
attractive returns in developing countries.
As a result, it is unsurprising that capital flows go from
rich to rich countries, rather than rich to poor
countries.
 III. Sovereign Risk
countries who default on their debts are often the
poorest countries which face difficulty borrowing from
the rest of the world.
So little funds are channeled through equity, and that
overall private lending rises more than proportionally
with wealth.
All strongly support the view that credit markets and
political risk are the main reasons why we do not see
more capital flows to developing countries.”
Is there really a Lucas Paradox?
Empirics shows that use market prices, capital-output ratios are surprisingly
similar across countries and hince no Lucas paradox exists when returns to
capital are measured using market prices.
The authors then focus on the question: why is the relative price of
investment goods higher in poor countries? Appealing to the Balassa-
Samuelson hypothesis, which states that poor countries have low productivity
in the tradeable sector relative to the non-tradeable sector, Causa et al shows
that empirically under a two sectors model, relative price differences are
offset by total factor productivity differences. In other words, lower total
factor productivity in manufacturing explains the higher relative
price of capital in the poorest countries; PPP measures of the capital-output
ratio may be a more suitable measure than market
exchange rates, which are very volatile and relevant for internationally traded
goods only
 cont…
Lastly he conclude that
All postwar development policies is to stimulate
transfers of capital goods from rich to poor countries.
such transfers will be fully offset by reductions in
private foreign investment in the poor country due to
political risks, trading cost and information
asymmetry.
 Evaluation
Great appreciation is left for the author for his pioneer
justification ,and conclusion. The investigation has so
many things to be appreciated however,
The article lacks composition.
The article enable to show the reason empirically..
The author fail to recommend the remedy and for
further investigation.
 conclusion
In reality, explanations of the Lucas Paradox are likely
a combination of the factors identified above.
 massive capital flows from rich to poor countries are
not observed in practice suggest the failure of
conventional assumptions, in both market
fundamentals, international capital markets, and
methods of measurement /quantification of variables.
• hence further research is required to fill the gap.
Closing

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