Foreign direct investment in a small open economy

Abstract

Think of a small open economy interestingly positioned between the trade blocs of the NAFTA and the EU, with FDI in recent years resembling the pattern before the economic crash, making a pre-crash data set useful for exploring potential long-term trends. In this research, investment is explained by geographic location and country size, using a gravity model to account for the country's exceptional remoteness and sparseness. A unique extension of the gravity model applies the inverse hyperbolic sine (IHS) function. The IHS functional form is estimated together with fixed difference between investment sectors and trade blocs being estimated simultaneously, an analysis that is rarely possible. Results indicate that under these conditions, investment appears to be more driven by wealth than market size effects.