Foreign direct investment, economic growth, and volatility: a useful model for policymakers

The explosion of hypotheses addressing empirical relationships between foreign direct investment (FDI) and economic growth is to say the least, confusing. There is the positive view whereby FDI positively affects growth, the negative view where FDI negatively affects growth, and the dependent view where FDI may or may not have an effect on growth at all, but is conditional upon whether certain economic and social conditions are met in the receiving country. In other words, to date, dozens of variables and modeling methods have been used to determine the effect FDI has on economic growth, and all with different results. Essentially, parsimony and ease of interpretation have been replaced with confusion. The central theses of the most important arguments focus on the broad dissemination of FDI, an economy’s absorptive capacity, and how injections tend to depend upon cyclical components. We use existing theory to justify a simpler model using a single determinant that encompasses these characteristics. By interacting past growth with current FDI, policymakers can more easily draw inference from the estimated marginal effect. We prove this by applying the model to pooled, high income, emerging, and developing economy samples in order to gain a clearer picture of exactly to what extent, FDI affects economic growth. And since policy not only takes growth into consideration, but economic stability as well, we also apply our model to volatility. While the results differ across income groups and growth rates, the inference drawn from them is unambiguous.