FDI and Growth In the Solow-type standard neoclassical growth models, FDI is traditionally conceived as an addition to the capital

stock of the host economy (e.g., Brems, 1970). In this view, there are no substantial differences between domestic and foreign capital. More importantly, the impact of FDI on growth is similar to that of domestic capital. With diminishing returns to capital, FDI has no permanent impact on the growth rate. FDI will have, however, a shortrun impact on growth, which depends on the transitional dynamics to the steady-state growth path. However, new growth theories incorporate the role of knowledge or technology endogenously as a factor of production in its own right and provide for the possibility of non-diminishing returns to capital (Grossman and Helpman 1991, Romer 1994.) There are a number of conceivable channels through which FDI permanently affects the growth rate. A convenient way to think about these effects is by separating out how FDI affects each argument in the production function. FDI can affect output by increasing the stock of capital. However this impact is likely to be small under the assumption of perfect substitutability. Although the empirical evidence on this matter is ambiguous (Hanson, 2001), if foreign and domestic capital are complements the final impact of FDI on aggregate output will be larger as a result of these externalities. One can also think about the impact of FDI on labour. Once again, the expected impact is small and in this case it will be in terms of job creation. Yet, the role of FDI as knowledge and technology transfer becomes even more apparent as FDI has clearly a more import role in the augmentation of human capital than on the numbers employed. Consider the case in which foreign investment is carried out in activities in which the host economy has limited previous experience. In this case FDI will entail important knowledge transfers in terms of training of the labour force, skills acquisition, new management practices and organisational arrangements. The last and arguably the most important venue through which FDI affect economic growth is through technology. FDI inflows directly raise the levels of technology in the host economy. That can be for a variety of mechanisms. One plausible mechanism is that

FDI inflows increase the variety of intermediate products and types of capital equipment in the host economy (Borensztein et al., 1998). In so doing, FDI inflows lead to an increase of the productivity in the host economy. Another important mechanism through which FDI affects growth is learning. FDI inflows diffuse knowledge about production methods, product design and new organisational and managerial techniques. In this light, imitation becomes a crucial element. Another important mechanism is that FDI raises the productivity of domestic Research and Development activities. FDI and Trade There has been, traditionally, a divergence in terms of the development of the theories on FDI and international trade. Trade theory, attempts to explain why countries trade with each other and FDI theory tries to account for why firms produce abroad and invest in particular countries. In the neoclassical approach of trade theory, the paper of Mundell (1957) was the first to focus on the relationship between, capital movements and trade of commodities. In the HOS framework, in taking account of the assumptions of perfect competition and constant economies of scale, Mundell argued that a tariff protection would generate a perfect substitution between capital movements and trade of commodities. Moreover, the question of complementarity / substitution was raised again with the new international theory developed at the end of the 1970's and dealing with imperfect competition and increasing economics of scale. In the beginning, Vernon (1966) developed the famous product cycle model, in which he considered that FDI affiliates' production and sales in foreign market replace trade in the same market. Moreover, the "electric theory or the OLI: Ownership, location and internalisation paradigm developed by Dunning (1981) points out that trade and FDI as alternative strategies of multinational firms. In general, this microeconomic analysis of firm's internalisation choices predicts this substitute relationship between FDI and trade. Some earlier theoretical work has predicted either a substitute or complementary relationship between FDI and trade. These models are based on the imperfect competition, the economics of scale, the difference in production technologies, etc. Some have focused mainly on either vertical or horizontal FDI1. In the first case, firms separate geographically
1

Horizontal FDI is defined as investment in the same industry abroad as a firm operates in at home. In contrast Vertical FDI takes two forms: (1) backward vertical FDI: where an industry abroad provides inputs

their different stages of the value-added chain. In the second case, firms duplicate the entire production process in several countries with an exception for headquarters activities. The models of Helpman (1984) and Helpman and Krugman (1985) integrate vertical FDI into international trade theory. They show that FDI generates complementary trade flows of finished goods from foreign affiliates to parent companies or to the home country and intra firm transfers of intangible headquarters services from parent companies to foreign affiliates. On the other hand, in the models based on horizontal FDI, such as Markusen (1983), Brainard (1993), Horstmann and Markusen (1992), Markusen and Venables (1995), and Markusen (1995), foreign investment are alternatives modalities. The choice of multinational firms depends on the interaction between these key elements: the firm specific advantages (activities of research and development, managerial know-how, etc.), the plant-level scale economies, and transport costs, geographical and cultural distance costs. In these models, the substitutability between FDI and trade prevails over complementarity. According to the models of Brainard (1993) and Horstmann and Markusen (1992), when countries are identical in technologies, preferences, and factor endowments, the higher the value of firm-level scale economies and tariffs and transport costs relative to plant-level scale economies, the more likely is the presence of horizontal FDI. These models based on the trade-off between proximity and concentration postulate a substitution relationship between horizontal FDI and trade. Markusen and Venables (1995) further elaborated the theory to introduce asymmetries between countries in terms of market size, factor endowments, and technologies. Countries asymmetries make it possible for national and multinational firms and, therefore, trade and FDI to coexist. However, as countries become more similar in market size, relative factor endowments, and technical efficiency, FDI will increase and international economic activity will become increasingly dominated by MNEs, which displace trade, provided that transport costs are not very small.

for a firm's domestic production process and (2) forward vertical FDI: in which an industry abroad sells the outputs of a firm's domestic production processes.

The contributions within the theoretical literature show the ambiguity of the relationship between FDI and international trade. The conclusions of models are shared between substitutability and complementarity.