(ProQuest: ... denotes formulae omitted.)1.INTRODUCTIONForeign direct investment (FDI) and economic growth have attracted much attention from policy makers, development agencies, and researchers, not least because they hold huge potential of improving the welfare of the vast number of poor people living in developing countries, but also because they are expected to complement each other. This suggests that, holding other things equal, faster growing economies will attract higher inflows of FDI and higher levels of FDI will in turn boost growth in the recipient country. This is especially possible in the current wave of globalization where goods and services, labor, and international financial capital cross national-state borders with fewer restrictions than before. However, not all international capital inflows to developing countries are growth-inducing, yet some theoretical models make the argument for full international capital liberalization. One argument goes as follows: 'By breaking the constraint that domestic investment is limited to the volume of national saving, capital inflows can be used to finance a more rapid pace of growth than a country could achieve on its own' (Bosworth, 2005, p. 1). Capital inflows with short-term horizon are unlikely however to generate sustainable growth in developing countries.Short-term capital inflows were widely believed to have contributed to the financial crisis and subsequent economic crisis in East Asia in the late 1990s and in Mexico in 1994. And there is evidence that the recent financial crisis in the U.S. was propagated to developing countries through the short-term dynamics of international capital flows. Short-term capital can enter and exit a developing country at the same speed, generating severe economic and financial shocks, leaving that country in a worse economic and financial position upon exit. This makes the case for FDI stronger in developing countries; hence capital liberalization policy should crowd out short-term capital and crowd in FDI (Stiglitz, 2000). FDI has longer-term predictability relative to the short-term variety, so policy makers can incorporate FDI in the development process with less fear of 'sudden stops' and thus fewer shocks to their economies. Long-term capital inflows in the form of FDI will reduce uncertainty, increase productivity, and improve growth in developing countries.Thus, the benefits of the potential complementary effect of FDI and growth are more likely to be realized in developing countries - higher standard of living and reliable access of public goods through higher tax revenues. This paper studies how FDI responds to growth and whether FDI in turn stimulates growth in developing economies within a system of simultaneous equations model, using a three-stage least squares (3SLS) estimator. We go beyond many previous studies that only examined the effect of growth on FDI or the other way around, for example, Durham (2004), Reisen and Soto (2001), and Nair-Reichert and Weinhold (2001). From a policy perspective, this is important as the analysis here seeks to enhance our understanding of the relationship between FDI and economic growth and, we hope, informs policy outcomes in developing countries. Our paper makes several contributions to economic literature. First, the paper documents that FDI improves growth in developing countries but FDI does not respond significantly to growth.In our second contribution to the literature on growth and FDI, we construct several dimensions of political instability and examine their effect on growth and FDI in the simultaneous equations framework. We find that political instability affects growth and FDI differently. In our final contribution, we test whether these dimensions of political instability impact FDI and growth differently in Sub-Sahara Africa (SSA) relative to a global sample of developing countries. We do not find supporting evidence that political instability affects FDI and growth in SSA differently. …
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