The Marginal Product of Capital, Capital Flows, and Convergence

In the world of free capital mobility, theoretically capital flows from low-return to high-return locations. Capital inflows are presumably transformed to physical capital and increase output in the recipient countries. However, the literature led by Robert E Lucas (1990) has focused on the direction of flows but remains silent about the magnitude of gains from capital inflows. Our study proposes a new methodology to quantify the impacts of capital inflows on economic growth. We derive the estimation equation from a small open-economy growth model which has two key features. First, the investment good is nontraded and produced from traded consumption good. Second, prices of investment are driven by exogenous changes in productivity in the investment sector. In our empirical study, we employ annual data on 47 countries from 1970 to 2003. First, we construct the time series of country returns and find that the adjustment for price of investment doubles the standard deviation of returns. Next, we use the predicted scale of inflows to compute the gains from inflows, because the theory suggests that capital inflows contribute to output growth when they are driven by movements in returns. We present the model in Section I. The next section discusses the empirical methodology and results. We conclude in Section III.