Japan and the allocation puzzle in an aging world

Capital that flows from rich to poor countries can be important in equalizing living standards across countries. Various factors, however, contribute to the Lucas Paradox and the mixed empirical evidence on the direction of capital flows. Differences in fundamentals, or simply TFPs, international financial market imperfections, differential demographic aging across regions of the world, or fiscal institutions affect the dynamics of capital flows. This paper builds a general equilibrium model of the world economy under imperfect capital mobility, populated by overlapping generations of individuals in three regions: the High-income (HI), Middle-income (MI) regions and Japan. We show that both TFP and aging are important factors to explain capital flows from the MI region to the HI region in the future and that Japan will turn a net borrower in mid-century in a process where the MI region further accumulates its external wealth. An alternative transition path in which the MI region exhibits catch-up in the expansion of the pension system and the TFP growth throughout the century shows significant effects on the predicted external wealth position of Japan.