rental rate of capital, increases production via enhancing labor productivity, and introduces
new technologies embedded in the capital by moving capital from capital-rich countries to
capital-scarce economies. Some studies underlining these features of FDI are Hyun (2006),
Hsiao and Hsiao (2004), Zhang (2001) and Duttaray (2001). Some other studies, however,
argue that FDI may affect growth negatively, as it may deteriorate competition and may
corrupt the development path of the country in its own interests. Most empirical works have
found that FDI has a positive impact on economic growth. For example, Papanek (1973),
Balasubramanyam et al. (1996), Borensztein et al. (1998), Balasubramanyam et al. (1999),
Berthelemy and Demurger (2000), Obwona (2001), Reisen and Soto(2001), Zhang and
Ram(2002), Massoud (2003), Bengoa and Sanchez-Robles (2003), Basu et al. (2003), Saha
(2005), Li and Liu (2005), Johnson (2006), Basu and Guariglia (2007) found that FDI
enhances economic growth. Some other (and fewer) studies, on the contrary, such as Fry
(1993) and Bornschier et al. (1978), found that FDI may deteriorate economic growth as it
may distort the development path of FDI-receiving economy.1 In Annex A, we provide a
more detailed list of the literature and their main findings.
The alternative direction of causality that economic growth may be a determinant of
FDI is also a plausible conjecture. Indeed, figure 1 may be interpreted as economic growth
has some positive impact on FDI as well as the other way around. On theoretical grounds,
advocates of the idea that economic growth has positive impact on FDI argue that higher
growth rates of an economy stimulate the growth in demand, which implies greater
profitability opportunities for inflowing capital. Hence, capital movement must prefer higher
growing countries. On the other hand, opponents of the idea argue that lower growing
economies may imply higher profitability opportunities for capital, given that these
economies are capital-scarce and labor abundant. Empirical research on the issue has mixed
results. On the one hand, works such as Chowdhury and Mavrotas (2006), Saha (2005) and
Choe (2003) found that higher growth rates attract more FDI. On the other hand, studies like
Hansen and Rand (2006), Hsiao and Hsiao (2004) and Mencinger (2003) argue that high-
growing countries do not attract much FDI.
This study works out the two possible directions of causality together in a simultaneous
equation system for the case of OECD. We undertake a simultaneous equation system
because it would be technically wrong and therefore results would be unreliable were we
assume one-way causality. The simultaneous equation setup allows us to treat FDI growth and
economic growth variables endogenously. This is also supported by the causality studies such
as Chowdhury and Mavrotas (2006) and Choe (2003), which have shown evidence that there
is bi-directional causality between FDI and economic growth. Heuristically speaking, our
approach is rare in the literature; most empirical studies test direction of determination in one-
way. In our simultaneous equation model, we estimate the determinants of FDI and economic
growth for OECD countries through a panel data analysis. In particular, following Saha
(2005) and Li and Liu (2005), we use Generalized Methods of Moments (GMM) estimation
technique in a panel dataset for OECD countries. Another novelty in our paper is that we run
FDI growth rather than FDI inflow or FDI stock (sum of FDI inflows) against economic
growth. We believe that using FDI growth is more proper than FDI inflow or FDI stock.
Firstly, running a level value (FDI inflow or FDI stock) against percentage (economic growth
rate) is not proper in a simultaneous equation system. Secondly, as long as FDI inflow or FDI
stock are growing, which must be actually, percentage change of the level value would
1 Interestingly, some other studies like Alfaro et al. (2002), Carkovic and Levine (2002), Durham (2004), and
Herzer et al. (2008) found that there is no direct relationship between FDI and economic growth.
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