Question 4 Research has shown that most of the world’s FDI is flowing from rich countries to other rich countries and not from rich countries to poor countries. Is this patterns consistent with the theory of international capital flows and the theoretical assumption that the marginal product of capital (MPK) decreases as a firm’s or a country’s stock of capital becomes higher? Explain your answer. If you think that this observation is not consistent with the theoretical prediction, mention and discuss one possible factor that could explain why capital is ‘flowing in the wrong direction.’(6 points)
Unrestricted international capital flows can contribute to financial crises. Two important measures to resolve financial crises are rescue packages and debt restructuring. First, provide the definitions of these two measures. Second, explain how (i.e. through which channels) these measures can resolve financial crises. Third, discuss the downsides of these measures in terms of creating moral hazard behavior and free-rider problems. (14 points)
Suppose there are two assets, a domestic and a foreign one, that each pay a return of 10% during a boom and 2% during a recession. Suppose that there is 50% chance that the home country will experience a boom and the foreign country a recession. There is also a 50% chance that the situation will be the other way around. Based on this scenario, explain how capital controls will impact the wellbeing of investors and why capital controls may be particularly harmful for very risk-averse investors. (8 points)
Type your answer in the space between the two lines (word limit: 150).
