Foreign finance, wealth effects and economic development

In this paper a two-period model of the wealth effect of foreign capital flows on domestic investment in LDCs is developed. It is shown that the link between foreign capital flows and increases in domestic consumption is conditional on the productivity of the capital flow, repayment conditions and complementarity with domestic investment. Generalizations are made regarding the relative productivity and repayment terms of such broad categories of capital flows as unrequited transfers, direct investments and long-term flows to governments. The impact of variations in the terms on which foreign capital is received is related to the ‘wealth effect’ of the capital. The model is tested with pooled cross-section data for seventy countries in 1976 and 1977. Data limitations permit estimation of the effect of foreign finance on domestic investment only up to a monotonic transformation of the true values. Nevertheless, the hypothesized role of the wealth effect of the major categories of external finance can be tested. The results show that different types of foreign capital flows have differential impacts on investment as suggested by the model.