How Does Foreign Direct Investment Promote Economic Growth? Exploring the Effects of Financial Markets on Linkages

58 Pages Posted: 29 Sep 2006 Last revised: 4 Jul 2021

See all articles by Laura Alfaro

Laura Alfaro

Harvard University

Areendam Chanda

Louisiana State University, Baton Rouge - Department of Economics

Sebnem Kalemli-Ozcan

University of Maryland - Department of Economics; National Bureau of Economic Research (NBER); Koc University, Graduate School of Business

Selin Sayek

Bilkent University - Department of Economics; International Monetary Fund (IMF)

Date Written: September 2006

Abstract

The empirical literature finds mixed evidence on the existence of positive productivity externalities in the host country generated by foreign multinational companies. We propose a mechanism that emphasizes the role of local financial markets in enabling foreign direct investment (FDI) to promote growth through backward linkages, shedding light on this empirical ambiguity. In a small open economy, final goods production is carried out by foreign and domestic firms, which compete for skilled labor, unskilled labor, and intermediate products. To operate a firm in the intermediate goods sector, entrepreneurs must develop a new variety of intermediate good, a task that requires upfront capital investments. The more developed the local financial markets, the easier it is for credit constrained entrepreneurs to start their own firms. The increase in the number of varieties of intermediate goods leads to positive spillovers to the final goods sector. As a result financial markets allow the backward linkages between foreign and domestic firms to turn into FDI spillovers. Our calibration exercises indicate that a) holding the extent of foreign presence constant, financially well-developed economies experience growth rates that are almost twice those of economies with poor financial markets, b) increases in the share of FDI or the relative productivity of the foreign firm leads to higher additional growth in financially developed economies compared to those observed in financially under-developed ones, and c) other local conditions such as market structure and human capital are also important to generate a positive effect of FDI on economic growth.

Suggested Citation

Alfaro, Laura and Chanda, Areendam and Kalemli-Ozcan, Sebnem and Sayek, Selin, How Does Foreign Direct Investment Promote Economic Growth? Exploring the Effects of Financial Markets on Linkages (September 2006). NBER Working Paper No. w12522, Available at SSRN: https://ssrn.com/abstract=931608

Laura Alfaro

Harvard University ( email )

Cambridge, MA 02138
United States

Areendam Chanda

Louisiana State University, Baton Rouge - Department of Economics ( email )

Department of economics
Baton Rouge, LA 70803-6308
United States
225-578-3791 (Phone)

Sebnem Kalemli-Ozcan (Contact Author)

University of Maryland - Department of Economics ( email )

College Park, MD 20742
United States

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Koc University, Graduate School of Business ( email )

Rumelifeneri Yolu
34450 Sar?yer
Istanbul, 34450
Turkey

Selin Sayek

Bilkent University - Department of Economics ( email )

06533 Ankara
Turkey
+90 312 290 1406 (Phone)

HOME PAGE: http://www.bilkent.edu.tr/~sayek/

International Monetary Fund (IMF) ( email )

700 19th Street NW
Washington, DC 20431
United States

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