FDI and Economic Growth : The Role of Local Financial Markets *

The purpose of this paper is to examine the various links among foreign direct investment, financial markets and economic growth. We model an economy with a continuum of agents indexed by their level of ability. Agents have two choices: they can work for the foreign company in the FDI sector and use their inherited wealth to earn a return or they can choose to undertake entrepreneurial activities, which are subject to a fixed set-up cost. Financial markets allow entrepreneurs in the economy to finance the set-up costs and take advantage of knowledge spillovers from FDI. In addition to the analytical solution of the model, an empirical analysis is also provided using crosscountry data from different sets of countries between 1970-1995. To the best of our knowledge there has not been a theoretical and empirical study on the interaction between financial markets and FDI spillovers prior to this study. Our empirical evidence suggests that FDI plays an important role in contributing to economic growth. However, the level of development of local financial markets is crucial for these positive effects to be realized. JEL Classification: F23, F36, F43 ____________________ *We thank Eduardo Borenzstein, Ross Levine and Edmundo Murrugarra for their help with the data and Bent Sorensen and Alex Hoffmaister for valuable comments and suggestions. We received valuable comments from the participants of the macro seminar at Brandeis University and University of Houston. **Corresponding Author: Sebnem Kalemli-Ozcan, Department of Economics, University of Houston, Houston, Texas, 77204, Sebnem.Kalemli-Ozcan@mail.uh.edu.