Capital Flows to Developing Countries: The Allocation Puzzle

The textbook neoclassical growth model predicts that countries with faster productivity growth should invest more and attract more foreign capital. We show that the allocation of capital flows across developing countries is the opposite of this prediction: capital seems to flow more to countries that invest and grow less. We then introduce wedges into the neoclassical growth model and find that one needs a saving wedge in order to explain the correlation between growth and capital flows observed in the data. We conclude with a discussion of some possible avenues for research to resolve the contradiction between the model predictions and the data.