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The Paradox Of Rich To Poor Capital Flow

2099 words - 8 pages

According to the Solow Growth Model, all countries will eventually converge to their long run steady state. If we consider the usual assumptions, of countries producing the same goods with the same constant returns to scale production technology, using (homogenous) capital and labour as factors of production, differences in income per capita income will reflect differences in per capita capital. Therefore, essentially if capital is allowed to flow freely, new investments should occur only in the poorer economy. However this is certainly not the case in reality. Most of the net capital flow in the past four decades has been north-to-north (rich countries investing in other rich countries), rather than north-south (rich economies investing in poorer ones) as predicted by the Solow Growth Model.

Lucas (1990) compares the USA and India using data from 1988 to show that capital does not flow from rich to poor countries as predicted by the neoclassical growth model, and in setting out his simple framework he illustrates the paradox that exists. Assuming a production function y = Ax^B, the relative marginal productivity of capital (MPK) will be given by- rIndia/ rUS= (yIndia / yUS)^(β -1)/ β. Plugging the data from 1988 in, we find that the marginal product of India should be 58 times that of the USA, as a result of which all investment should flow from the US to India. This is where the paradox lies-in reality such flows are not observed. The law of diminishing returns implies that the marginal productivity of capital will be higher in poorer countries. If this model is correct, and the capital markets are free and complete, investment should take place in India and other poor countries, and not in the USA or other richer countres, however, as already stated- this is far from what is observed in reality.

Lucus puts forward three explanations for this paradox-most importantly (in his opinion) differences in human capital, secondly the external benefits of human capital, and lastly, capital market imperfections. Eaton et al.‘s Pure Theory of Country Risk(1987)was published before Lucas published his paper outlining the famous Lucas Paradox(1990), and in their analysis, they claim that the reason for the lack of capital flows from north to south, or from rich to poor countries is the failure of the capital market. Lucas, on the other hand stresses more on the view that the main explaination for the Lucas Paradox is that capital, and most importantly human capital, is far less productive in poorer countries. Lucas suggests adding human capital as an extra variable will remove the paradox, and essentially, in order to improve capital flows from the rich to the poor, countries must concentrate on improving the quality of their human capital in particular, and generally capital and labour productivity. The alternative position, stresses that factors such as asymmetric information, unenforceable property rights sovereign risk are the reason behind...

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