capture the same regularity.2 We consider OECD countries in this research because (i) its
FDI data are wider and reliable, (ii) covers mainly developed countries, a better representative
of long-run FDI growth and economic growth rates.
The organization of paper is as follows. Section 2 portrays an illustrative theoretical
framework. We show that FDI determines economic growth and that economic growth is a
determinant of FDI. Section 3 first describes the data and its limitations and next discusses the
simultaneous equation system. Section 4 presents the findings of the model and its
implications. The last section provides some concluding remarks.
2. An Illustrative Framework3
Let us assume a single-good open economy populated by identical households. Suppose that
utility function of the representative consumer is defined as
∞
U (c) = ∫ e-ρtu(c)Ldt
(1)
0
where U (c) is the overall utility, ρ is the subjective rate of discount, u (c) is the momentary
felicity function, c is consumption per capita and L is the labor which grows at rate n . We
marginal utility. The representative household’s optimization problem requires construction
of an optimal control problem, which yields:
assume that momentary utility is defined as u (c) =
c1-θ
-1
1-θ
where θ is the elasticity of
(2)
In (2), r is the real rate of interest and a dot on top of a variable indicates a time derivative of
the variable. Equation (2) is nothing but an arbitrage condition between “to consume today”
versus “to consume tomorrow”. According to (2), if the real rate of interest is greater than the
subjective rate of discount, then consumers prefer not to consume today to enjoy higher
consumption tomorrow.
We assume in this open economy that capital may freely move between borders. We
further assume that domestic and foreign capital are perfect substitutes as factor of
production; hence each pay the same rate of return, r , the world interest rate. Suppose that
capital K * that exists in a domestic country at a particular time has two possible ownerships:
domestic residents and foreigners. Suppose also that K is capital that belongs to domestic
residents. Hence, K* -K represents the sum of foreign investments in the domestic country.
In another interpretation, K * - K represents net claims by foreigners on the domestic
economy. For matter of illustration, we assume that K* - K > 0, without loss of generality.
The only function of openness in this model is the free movement of capital; that is, labor is
immobile. Suppose that the production technology is represented by
2 Were the variable run against economic growth was a constant FDI inflow, then a constantly falling FDI/GDP
yielding constant positive economic growth must have been possible. Visibly, this is implausible.
3 This section is inspired from chapter 3 of Barro and Sala-i-Martin (2005).
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