The Marginal Product of Capital, Capital Flows and Convergence

The neoclassical theory of economic growth suggests that capital inflows increase output because foreign financial capital is transformed into physical capital. This study quantifies the output gains from capital inflows by exploiting fluctuations in the price of investment relative to output. The theory predicts that capital inflows are positively correlated with the domestic price-adjusted return to capital. It also predicts that a fall in productivity in the investment good sector reduces the gains from capital inflows. In the empirical part, we find weak evidence that capital flows are driven by movements in return to capital. The gains from capital flows are found to be quite small.