Free Capital Flow Model

Summary

Assumptions

  • Based on Solow Model
  • Economy is open to capital flows therefore use law of one price where rental rate is the same globally.
  • Small economy (compared to rest of the world) - i.e. no effect on global factor prices
  • Ignore human capital
  • r=MPK=αAk^(α-1)
  • r_w=r

Model/Theory

  • k=(αA/r_w)^1/(1-α) This implies that capital/labour ratio depend on world rental rate of capital - whereas in previous Solow model only domestic factors like the savings rate and growth rate of population mattered.
  • y=Ak^α=A^1/(1-α)*(α/r_w)^α/(1-α). This implies that saving rate is irrelevant for level of GDP/capita!

Predictions

  • For countries with high savings rates openness to capital flow will lower the level of GDP/worker as capital will flow abroad to countries where its MPK is higher (because the increase in capital stock would lower the MPK domestically). However GNP is still higher in both high and low saving countries when open vs closed.

Evidence

  • If free capital model holds savings and investment should be uncorrelated whereas in a closed model they are perfectly correlated. Having 1960-74 study found saving and investment are highly correlated therefore the assumption of free capital movement is inappropriate. Savings retention rate had fallen from 0.89 in 1970s to 0.60 between 1990-97.

Evaluation

  • Crucially a high savings rate may still make a country better off based on GNP/capita and owning overseas assets.
  • For a country with a low savings rate openness should raise GDP, at least much more rapidly than it could from domestic savings.
  • In general openness to free capital is not sufficient to be the primary channel of increasing GDP/capita - thus openness must improve productivity.