TY - JOUR
T1 - Does institutional quality resolve the Lucas Paradox?
AU - Akhtaruzzaman, Muhammad
AU - Hajzler, Christopher
AU - Owen, P. Dorian
N1 - Publisher Copyright:
© 2017 Informa UK Limited, trading as Taylor & Francis Group.
PY - 2018/1/26
Y1 - 2018/1/26
N2 - The Lucas Paradox observes that capital flows predominantly to relatively rich countries, contradicting the neoclassical prediction that it should flow to poorer capital-scarce countries. In an influential study, Alfaro, Kalemli-Ozcan, and Volosovych (AKV) argue that cross-country variation in institutional quality can fully explain the Paradox, contending that if institutional quality is included in regression models explaining international capital inflows, a country’s level of economic development is no longer statistically significant. We replicate AKV’s results using their cross-sectional IFS capital flow data. Motivated by the importance of conducting inference in statistically adequate models, we focus on misspecification testing of alternative functional forms of their empirical model of capital flows. We show that their resolution of the Paradox relies on inference in a misspecified model. In models that do not fail basic misspecification tests, even though institutional quality is a significant determinant of capital inflows, a country’s level of economic development also remains a significant predictor. The same conclusions are reached using an extended dataset covering more recent IFS international capital flow data, first-differenced capital stock data and additional controls.
AB - The Lucas Paradox observes that capital flows predominantly to relatively rich countries, contradicting the neoclassical prediction that it should flow to poorer capital-scarce countries. In an influential study, Alfaro, Kalemli-Ozcan, and Volosovych (AKV) argue that cross-country variation in institutional quality can fully explain the Paradox, contending that if institutional quality is included in regression models explaining international capital inflows, a country’s level of economic development is no longer statistically significant. We replicate AKV’s results using their cross-sectional IFS capital flow data. Motivated by the importance of conducting inference in statistically adequate models, we focus on misspecification testing of alternative functional forms of their empirical model of capital flows. We show that their resolution of the Paradox relies on inference in a misspecified model. In models that do not fail basic misspecification tests, even though institutional quality is a significant determinant of capital inflows, a country’s level of economic development also remains a significant predictor. The same conclusions are reached using an extended dataset covering more recent IFS international capital flow data, first-differenced capital stock data and additional controls.
KW - Lucas Paradox
KW - capital flows
KW - foreign direct investment
KW - institutions
KW - misspecification testing
UR - http://www.scopus.com/inward/record.url?scp=85018264413&partnerID=8YFLogxK
U2 - 10.1080/00036846.2017.1321840
DO - 10.1080/00036846.2017.1321840
M3 - Article
SN - 0003-6846
VL - 50
SP - 455
EP - 474
JO - Applied Economics
JF - Applied Economics
IS - 5
ER -