Open Economies Review

, Volume 25, Issue 1, pp 195–224 | Cite as

International Capital Flows in the Model with Limited Commitment and Incomplete Markets

  • Jürgen von Hagen
  • Haiping Zhang
Research Article


Recent literature has proposed two alternative types of financial frictions, i.e., limited commitment and incomplete markets, to explain the empirical patterns of international capital flows between developed and developing countries in the past two decades. This paper integrates these two frictions into a two-country overlapping-generations framework to facilitate a direct comparison of their respective effects. In our model, limited commitment distorts the investment made by agents with different productivity, which creates a wedge between the interest rates on equity capital vs. credit capital; while incomplete markets distort the investment among projects with different riskiness, which creates a wedge between the risk-free rate and the mean rate of return to risky capital. We show that the two approaches are observationally equivalent with respect to their implications for international capital flows, production efficiency, and aggregate output.


Financial development Financial frictions Foreign direct investment Incomplete markets Limited commitment International capital flows 

JEL Classifications

E44 F41 



We would like to thank Dirk Krueger, Vasia Panousi and participants at 14th ZEI Summer School and the 2011 European Meetings of Econometric Society in Oslo for helpful comments and suggestions. Financial supports from Singapore Management University and German Research Foundation are gratefully acknowledged.


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Copyright information

© Springer Science+Business Media New York 2014

Authors and Affiliations

  1. 1.Department of EconomicsBonn University, Indiana University, and CEPRBonnGermany
  2. 2.School of EconomicsSingapore Management UniversitySingaporeSingapore

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