The Allocation of Capital

This thesis outlines an alternative theoretical framework based on the work of R. Lucas (1990), who discovered that capital does not flow from rich to poor countries as it was framed by neoclassical theory. Because of the opposition of his discovery to neoclassical theory’s explanation of capital flows and their allocation at international level, this theoretical inconsistency is called “Lucas’ paradox”. Later, during the past three decades academics emphasized different factors as the main reason of capital inflows into developed counties in order to explain this phenomenon, and most of the produced explanations were limited to the data from the twentieth century. The main aim of this thesis, therefore, is to examine previous research in this field and to identify the factors explaining capital inflows in past few years. The key aspect of the thesis is capital flows, which is understood as the savings-investment difference and foreign direct investment. Based on a literature review, seven independent variables were chosen to examine their relationship with capital inflows. Multiple regression analysis covers data sample consisting of one hundred thirty countries, and show that both institutional quality and economic policies have significant effect on attracting capital. In a nutshell, countries with low corruption, high legal order and quality of democracy, low inflation and high political stability receive more capital inflows.