Why Does Capital Flow to Rich States?
The magnitude, and even the direction, of net international capital flows does not fit neoclassical models well; in particular, rich countries attract net flows that should go to poor, capital scarce countries according to the models. The 50 U.S. states comprise an integrated capital market with very low barriers to capital flows, which makes them an ideal testing ground for neoclassical models. We develop a simple frictionless open economy model with perfectly diversified ownership of capital and find that capital flows between the U.S. states are consistent with the model. Therefore, the small size and “wrong” direction of net international capital flows are likely due to frictions associated with national borders rather than to inherent flaws in the neoclassical model.