The Marginal Product of Capital, Capital Flows and Convergence

The neoclassical theory of economic growth suggests that capital inflows raise the speed of convergence because foreign financial capital is transformed into physical capital. We propose a new methodology to quantify the size of capital inflows which are transformed into physical capital. We use the predicted scale to calculate the output gains from capital flows. Our methodology takes into account cross-country differences and fluctuations in the price of investment goods relative to output. The theory predicts that inefficiency in producing investment goods reduces the gains from capital inflows. A sizable fraction of capital inflows is found to be transformed into physical capital in only a few countries. However, the gains are found to be extremely small.