Financial Development and Capital Flows : Appraisal of the "Allocation Puzzle" By Schumpeterian Growth

We explore the role of financial development to explain the negative correlation between capital inflows and productivity catch-up. Evidence shows that countries with higher productivity growth rates export capital while countries with lower productivity growth rates receive positive capital inflows. This is contradictory to the predictions of the neoclassical growth model. Gourinchas and Jeanne (2013) called this paradox the "Allocation Puzzle". Under perfect credit market, our calibrated Schumpeterian growth model also predicts a positive correlation between capital inflows and productivity catch-up, and the "Allocation Puzzle" is more prevalent than previously thought. We generalize our results to a larger sample of countries and a longer time period. We then introduce credit constraints in our model to address this paradox. Our show that, when the level of financial development prevents countries from catching up relative to the world technological frontier, countries import capital to compensate for their insufficient level of domestic savings