Matsuyama (2014, Journal of the European Economic Association) showed that cross-country differences in the institutional quality (IQ) of domestic credit markets generate productivity differences through the composition of credit across heterogeneous investment projects, and that such institution-induced productivity differences move investment and international capital flows in directions opposite to exogenous productivity differences — producing, among other patterns, U-shaped responses in which capital flows out of middle-income countries into both low-income and high-income countries. The paper treats IQ as an exogenous country characteristic and explicitly leaves open the extension in which IQ is endogenous: governments or societies choose how much to invest in improving credit-market institutions or how much to enforce payments to lenders, so that productivity and institutional quality are jointly determined. No subsequent work in the literature is known to build the two-way-causality extension or characterize its consequences for the patterns of capital flows, so the problem remains open: formulate an equilibrium world-economy model nesting Matsuyama's IQ-to-productivity mechanism in which institutional quality is chosen by a government, and characterize how the endogenous feedback between productivity and IQ alters the equilibrium patterns of investment and international capital flows relative to the exogenous-IQ benchmark.

Background

The starting point is the Lucas paradox: Lucas (1990) observed that capital does not flow from rich to poor countries even though the marginal product of capital is higher in poor countries, so the neoclassical growth model predicts large capital inflows to the developing world that are not observed. A large empirical literature treats the quality of a country's institutions as a leading candidate explanation; for example, Alfaro, Kalemli-Özcan, and Volosovych (2008) find that institutional expropriation risk accounts for much of the failure of capital to flow to poor countries. On the theoretical side, Gourinchas and Jeanne (2013) documented the related 'allocation puzzle': capital tends to flow toward countries that grow less fast, contrary to the neoclassical prediction.

Matsuyama (2014) proposes a mechanism linking institutions, productivity, and capital flows in general equilibrium. The world economy consists of many countries; within each country, savers lend to entrepreneurs who borrow to run indivisible investment projects that differ in productivity RjR_j (output of capital per unit invested). Credit markets are imperfect: a borrower running a project of type jj can pledge only a fraction λj<1\lambda_j < 1 of the project's revenue to lenders, where λj\lambda_j depends on the country's institutional quality parameter θc\theta_c — an inverse measure of the institutional quality (IQ) of the domestic credit market, with worse institutions (higher θ\theta) lowering pledgeability. Because more productive projects also have bigger agency problems (their returns are harder to pledge), a lower IQ shifts the composition of credit toward less productive but more pledgeable projects. The productivity of the funded project, R(θ)R(\theta), is therefore decreasing in θ\theta: institutional differences induce productivity differences. This builds on Matsuyama's earlier work on credit market imperfections and international capital flows (Matsuyama 2005), financial market globalization and symmetry-breaking (Matsuyama 2004), and credit traps (Matsuyama 2007).

The central result is that institution-induced productivity differences have effects on investment and international capital flows that are opposite to those of exogenous productivity differences. Higher productivity from an exogenous source raises a country's investment and generates capital inflows; higher productivity caused by better institutions raises the return to investment but also tightens the competition for funds, and the combined effect can generate U-shaped responses of investment and capital flows to IQ. Among the implications: capital can flow out of middle-income countries into both low-income and high-income countries; and a country starting from a very low IQ can experience both growth and a current-account surplus after a successful institutional reform. By construction, quasi-linear preferences make the aggregate saving schedule independent of the wage rate, which deliberately shuts down the saving channel that other models of global imbalances (such as Buera and Shin 2017, where financial frictions decline along an exogenous reform path) emphasize.

In this model, IQ (θc\theta_c) is an exogenous characteristic of a country. The concluding section of the paper states that, in reality, causality runs in both directions: the quality of domestic credit markets may itself depend on the level of productivity or development, so that IQ should be endogenous. The paper suggests modeling this reverse causality by introducing governments that choose how much to invest in improving credit-market institutions or how much to enforce payments to lenders, and leaves open the question of how such two-way causality between productivity and IQ affects the equilibrium patterns of capital flows, offering the model 'as a useful building block' for that extension. Related modeling issues noted there include government non-commitment in enforcement and the possibility that governments cannot discriminate between domestic and foreign lenders, a theme developed in the risk-sharing model of Broner and Ventura (2016).

Problem Statement

Formulate and analyze an equilibrium model of the world economy that nests the mechanism of Matsuyama (2014) — cross-country differences in the institutional quality of domestic credit markets alter the composition of credit across heterogeneous investment projects and thereby induce productivity differences — but in which institutional quality is endogenous rather than an exogenous country characteristic. In particular, introduce an actor (for example, a government) that chooses how much to invest in improving domestic credit-market institutions and/or how much to enforce payments to lenders, subject to resource costs and, where relevant, to the commitment and lender-non-discrimination constraints discussed in the source, so that productivity and institutional quality are jointly determined in equilibrium. Then characterize how this two-way causality between productivity and institutional quality alters the equilibrium patterns of investment and international capital flows relative to the exogenous-IQ benchmark of the original model: in particular, whether the U-shaped responses of investment and capital flows — capital flowing from middle-income countries to both low-income and high-income countries, and a country starting from very low institutional quality experiencing both growth and a current-account surplus after a successful institutional reform — survive, are amplified, disappear, or are replaced by qualitatively new patterns such as multiple equilibria, path dependence, or institutional and development traps.

References

  1. Kiminori Matsuyama (2014), 'Institution-Induced Productivity Differences and Patterns of International Capital Flows', Journal of the European Economic Association 12(1): 1-24, DOI 10.1111/jeea.12045, https://doi.org/10.1111/jeea.12045
  2. Robert E. Lucas, Jr. (1990), 'Why Doesn't Capital Flow from Rich to Poor Countries?', American Economic Review 80(2): 92-96; reprinted as a Routledge (2017) volume of the same title, DOI 10.4324/9781912281152, https://doi.org/10.4324/9781912281152
  3. Laura Alfaro, Sebnem Kalemli-Ozcan, and Vadym Volosovych (2008), 'Why Doesn't Capital Flow from Rich to Poor Countries? An Empirical Investigation', Review of Economics and Statistics 90(2): 347-368, DOI 10.1162/rest.90.2.347, https://doi.org/10.1162/rest.90.2.347
  4. Kiminori Matsuyama (2004), 'Financial Market Globalization, Symmetry-Breaking, and Endogenous Inequality of Nations', Econometrica 72(3): 853-884, DOI 10.1111/j.1468-0262.2004.00514.x, https://doi.org/10.1111/j.1468-0262.2004.00514.x
  5. Kiminori Matsuyama (2005), 'Credit Market Imperfections and Patterns of International Trade and Capital Flows', Journal of the European Economic Association 3(2-3): 714-723, DOI 10.1162/jeea.2005.3.2-3.714, https://doi.org/10.1162/jeea.2005.3.2-3.714
  6. Kiminori Matsuyama (2007), 'Credit Traps and Credit Cycles', American Economic Review 97(1): 503-516, DOI 10.1257/aer.97.1.503, https://doi.org/10.1257/aer.97.1.503
  7. Pierre-Olivier Gourinchas and Olivier Jeanne (2013), 'Capital Flows to Developing Countries: The Allocation Puzzle', Review of Economic Studies 80(4): 1484-1515, DOI 10.1093/restud/rdt004, https://doi.org/10.1093/restud/rdt004
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  12. Been-Lon Chen, Yunfang Hu, and Kazuo Mino (2025), 'Capital Flows and Wealth Distribution in a Global Economy with Asymmetric Countries', Economic Modelling 151: 107214, DOI 10.1016/j.econmod.2025.107214, https://doi.org/10.1016/j.econmod.2025.107214