Financial Efficiency and the Lucas Puzzle

I present a model that provides a theoretical solution to the Lucas Puzzle using Financial Efficiency, which is a time-varying component of TFP. The model predicts that a financially underdeveloped economy is to benefit from financial integration through FDI capital inflow only if it experiences faster technological growth, or faster Financial Development than the developed economy. Fitting the model to the data of India, I find that a sharp increase in India’s Financial Efficiency since 1990 provides a test for the theoretical prediction above and its congruence with the empirical part of the model. Increases in India’s capital per worker and Foreign Direct Investment capital inflow during the same period serve as external validation of the model