Why Does Capital Flow to Rich States?

The magnitude and the direction of net international capital flows does not fit neo-classical 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 and not due to inherent flaws in the neoclassical model.