Abstract

Literature notes many factors as affecting capital flows, but the effects of these flows over the recipient economies and the overall effect over growth are highly debatable. This study claims that although capital flows may be required for the increase in output, other forces are causing this growth and creating the demand for capital. We construct a model in which growth requires both decisions of firms regarding training of managers in order to expand, representing the absorption capacity of the firms, and capital for the firms’ expansion. The model shows that in early stages of development when output is low, capital inflows are increasing with an increase in the output, but are not the cause for the output growth. However, when output is higher, an increase in the output is associated with financial outflows since the local savings are increasing by more than the local demand for capital. Although we cannot empirically test the model, we use cross-country regressions to show that capital flows are in-line with the predictions of the model and manage to explain half of the variations in net FDI flows per capita using the stage of development. Many policies regarding capital flows may be, therefore, irrelevant.