Fdi Effects On Economic Growth

There are two major theories that explain why FDI should have a positive impact on growth: the capital formation theory and the technological spillovers theory. The capital formation theory, as one might predict, emphasizes FDI’s role as capital. According to the neoclassical growth model put forth by Solow (1956), an increase in the capital stock available in an economy leads to an increase in production, which then corresponds to an increase in the growth rate of output. Since FDI is a source of physical (and financial) capital to the host country, increases in FDI should raise the overall level of capital stock available for production. Thus, under the neoclassical framework, an increase in foreign-owned capital stock then leads to higher

FDI’s projected role as a diffuser of technology or knowledge implies that it can have a direct effect on growth (Borensztein et al 1998), especially within the framework of endogenous growth theory, which emphasizes the accumulation of knowledge as the driver of long-run economic growth. Kinoshita (1999) explains that the technology diffusion process can take on any of four different forms: the imitation effect, the training effect, the linkages effect, and the competition effect. As firms from developed countries set up subsidiaries or factories in developing countries, these firms might introduce more efficient/advanced technologies to local markets. Through contact in the marketplace, local producers might copy the advanced technologies and practices that are implemented by their foreign-owned counterparts, causing increased production through the use of more efficient technology. This diffusion mechanism is called the imitation

These theories were based on the classical theory of trade in which the motive behind trade was a result of the difference in the costs of production of goods between two countries, focusing on the low cost of production as a motive for a firm’s foreign activity. For example, Joe S. Bain only explained the internationalization challenge through three main principles: absolute cost advantages, product differentiation advantages and economies of scale. Furthermore, the neoclassical theories were created under the assumption of the existence of perfect competition. Intrigued by the motivations behind large foreign investments made by corporations from the United States of America, Hymer developed a framework that went beyond the existing theories, explaining why this phenomenon occurred, since he considered that the previously mentioned theories could not explain foreign investment and its