Exogenous growth model:
The Harrod-Domar model explains the economic growth rate in terms of the level of savings relatively to the productivity of capital. It assumes that growth is financed out of savings; therefore the saving rate is the engine towards economic growth. This model concludes, that countries with higher saving rates are assumed to benefit in the form of higher income per capita.
Harrord and Domar stated three concepts of growth. First is warranted growth, where the product of capital output and savings rate equals to savings, which equals to investment. Investment and saving grow at the same constant rate that generates growth. The second is natural growth, where the growth of population leads to larger labour force. Labour force, which is growing at constant rate, increases productivity of labour and promotes technological progress. Natural growth assumes that a larger workforce generates larger aggregate output levels. The third is actual growth, which is the actual change in aggregate output.
The main idea of this model is implementation of quantity of labour and capital accumulated and more investment, which generates economic growth. The model suggests that economic growth is affected by policies to stimulate investment by increasing savings and generate capital output more productively with technological advances. Therefore growth is affected by both physical and human capital.
The Harrod-Domar model is adequate for developing countries, due to oversaturation of labour supply relatively to physical capital. The lack of physical capital is a consequence of the low saving rate. It can be adjusted by government decisions through fiscal and monetary policies. Savings can be increased by setting higher interest rates to encourage people to save, introduction of tax benefits for stimulating FDI from the developed world results in physical capital accumulation and technological progress.
Harrod-Domar model has evolved by Robert Solow (1956) adding labour as a factor of production. The basic assumptions of this model are: constant returns on scale, the diminishing marginal productivity on capital, substitutability between labour and capital and exogenously determined technological progress. He argued, that growth rate when economy converges to the steady state level of output is only determined by capital accumulation and implemented by the savings ratio in the short-run.
In the long-run the growth rate is exogenously determined; therefore the steady state rate of growth only depends on technological progress and labour-force growth. In Solow’s model new capital is more effective than the old capital, given the technological improvement over time, new capital is assumed to be more productive. Most of the developing countries have been experiencing problems with developing new technologies. The need of introduction of new technology has encouraged governments to find the way to attract it. FDI an effective
Endogenous growth model:
Paul Romer, Robert E. Lucas and Robert J. Barro developed the new endogenous theory. The basic assumptions of this model are: increasing rates of return on human capital, constant returns to capital. Human capital has increasing returns to scale, but the rate of growth depends on the types of capital the country invests in. Endogenous growth theory emphasizes that investment in R&D is the main source of technological progress. Therefore even when labor and capital have constant returns to scale, economy cannot develop without technology progress.
Romer (1990) suggests that qualitative development of labour force generates new products and ideas that underlie technological progress. He also notes that those countries with a large and well developed labour force experience a more rapid rate of introduction of new goods and thereby tend to grow faster. Rebelo (1990) and Barro (1990) state that investment ratio and per capita growth tend to move simultaneously. Barro (1995) further indicates that for a country to grow adequately, human capital in the form of education and health is an important element. He specifies that the faster a country grows, the greater its current level of human capital development, since physical capital expands rapidly to match a high endowment of human capital. Also, the country is better equipped to acquire and adapt the efficient technologies that have been developed in the leading countries. Sach and Warner (1997) also noted that a rapid increase in human capital development would result in rapid transitional growth. Many of developing countries have an excess supply of labour, but on the other hand lack of physical capital to achieve growth. FDI is one of the sources to exploit and develop advanced technologies in developing economies.
The main implication of up to date growth theory implies that policies that embrace openness, competition, change and innovation will promote growth.
Determinants of growth:
Many theoretical approaches have considered other macro non-economic factors influencing economic performance, such as social and cultural factors, political systems, and geographical determinants. Investigation of the determinants of economic growth has achieved various
Investment is considered to be the most crucial determinants of economic growth. Exogenous and endogenous growth models identified it as an engine of growth. However, neo-classical growth model believes that investment affects steady state level of output only in the short-run, while the endogenous growth model argues on the long-term effects.
Human capital is significant source of economic growth, has increasing returns to scale over time. The accumulation of human capital is major factor of development process, which can be influenced through education and training. Education and training leads to an increase in the level of human capital; therefore it raises output per worker and stimulates economic development. Studies, explaining their relationship, have emphasised the factors, which influence the quality of human capital and have found the evidence that educated labour force is important determinant of economic growth. Barro (1991) conducted, that human capital can be influenced by public programs for schooling and health. Better quality of education leads to well educated workforce, which attracts potential FDI from developed countries
Neo-classical growth model states that quality and quantity of physical and human capital employed affect total output of the economy. When it reaches the constant rate and full employment, economic growth can occur through improvement in capital stock or quality of labor force.
The role of technological progress has been discovered to be a key driver of economic growth, especially introduction of new factors, such as knowledge, innovation and public infrastructure stimulate economic growth. Romer and Lucas argued, that in the long run economic growth is stimulated by implications of monetary and fiscal policies. The endogenous growth models suggest, that the economy would never converge due to increasing returns to scale.
Foreign Direct Investment is argued to be a primary technology transfer source in addition to economic growth. This major responsibility is stressed in numerous models for endogenous growth theory. The experimental literature which examined the effect of FDI on growth led to the findings that investigate the link between them
Effects on location of FDI:
The broader the nature of the host market economy the more competitive it is. Large competitiveness reduces the possibility of monopoly profits and therefore prevents the incentive for foreign direct investment to benefit from these abnormal returns. FDI is motivated to benefit from monopoly profits in those industries which are relatively narrow specialized and therefore less significant to foreign competitors. Domar argued that that the large number of small firms in the economy, which are too small for research and to weak for action wouldn’t maximize the economic growth.
The motivation of FDI location is influenced by many factors of the economy, which attract the multinational companies to explore the different parts of the foreign country, from peripherally territories to more developed regions.
The size of market is argued to have a positive effect on FDI location ( Billington, 1999). Expansion into the foreign markets gives greater sales revenue and market share. Gross domestic product is used as a measure of market size. Kravis and Lipsey (1982), Wheeler and Mody (1992) and Braunerhjelm and Svenson (1996) make a comparison across countries, and they all find that the market size has a positive effect on FDI. However, Scaperlanda and Mauer (1969) find that this did not affect the location decision.
Labor availability has a positive effect on the FDI location. It is valued by its productivity level and cost. Labour market flexibility is a key positive determinant on the choice of location for foreign-owned firms (Haaland and Wooton 2003). On the other hand Dewitt argued that when the firms act strategically, then an inflexible market attracts FDI. This is because firms must commit to a high level of future output, so that there is some optimal level of flexibility. Further, a switch from a flexible to an inflexible labor market may lock-in or anchor previous FDI, making it more costly to exit (Dewitt et al, 2004). Labour costs, measured by the average hourly wage rate, are found to have an adverse effect on FDI by Wheeler and Mody !1992), but as Billington (1999) observes, higher labour costs could be offset by higher productivity levels.
Macroeconomic conditions effects FDI mostly through corporate tax and the exchange rate. Generally, high tax rate have a negative influence on FDI location, since it reduces profits. On the other hand fluctuations of a host country exchange rate make FDI more risky. A depreciation of the host country currency makes it cheaper for the firm to set up the production, but at the same time reduces the value of repatriated profits.
Government can influence the FDI location through financial or non-financial decisions. Provide an inducement in order to tract FDI, may result in the congestion and as follows inability to prosper or have no effect on FDI at all.
The general level of infrastructure is a potential attractor for inward investment. High level of infrastructure may assume a high level of urbanization, therefore a large number of consumers in the market. Furthermore, when the large number of consumers results on the increase of the number of firms in the region, this is potentially increase an industrialization level is associated beneficial spillovers, known as agglomeration economy.
Massive capital investment is very essential for generating a positive economic growth. Competition for private direct capital has grown constantly over the world in the last decades. FDI is a source of macroeconomic growth for developing countries, which attract foreign direct capital through the different liberalization policies developed presently. The great influence brought in by foreign investors, who believe, that FDI is beneficial in economic terms, rising expectations of the great perspectives of industrial and developing countries.
Foreign Direct Investment and Economic Growth
One of the main purposes to analyze the positive spillowers from FDI is to measure the contribution of FDI into the host economy. The impact of FDI on the host economy is measured by the costs and benefits the economy faces. FDI promotes growth by an increase in productivity factor, technological progress and positive spillovers on the economy. When a Multinational company comes to the developing market, one of the key issues is the positive externalities potential the economy will generate through the increase in the labor productivity and product quality will improve. Furthermore, bringing foreign capital to the domestic workers would be an alternative for emigration for them, as a result it strengths the employment level. Foreign firms generally pay higher wages than local; on one hand it does not necessary lead to an increase in wages in local firms, but on the other hand improves the wage level across the host country. Foreign firms are beneficial in terms of efficiency and productivity level compared to domestic firms. The spillower effect for the host country arises; local firms could increase their efficiency level or would be forced to in order to stay in business. As a result, competition can reduce the number of local producers in the region, possible resulting in an overall reduction of regional employment where the foreign producer has greater scale and economies of scale (Driffield and Munday, 1998).
Findlay (1978) conjectures that FDI improves management structure and technological progress, developed by foreign investors in the host country. However, the FDI externalities could slow down the economical conditions of the host country if weak financial markets and lack of human capital exist. Borensztein, De Gregorio, and Lee (1998) and Xu (2000) show that FDI brings technology, which translates into higher growth only when host nation has minimum threshold of the stock of human capital. Alfaro, Chanda, Kalemli-Ozcan and Sayek (2004), Durham (2004), and Hermes and Lensink (2003) provide evidence that only nations with well-developed financial markets achieve significantly from FDI in terms of growth rates.
