Foreign direct investment and relative capacity: Theory and evidence

This paper builds a bilateral FDI‐output model to study intermediary roles played by the relative differences in human capital and technology in triggering the gross‐output‐enhancing effect of inward foreign direct investment (FDI). Our model develops several testable hypotheses to assess how these intermediary factors—the differences between leader and follower countries' capabilities—determine the technology transfer and shorten the gross output gap between the frontier and follower countries. In our empirical work, we employ country‐level panel data that contain 67 countries from 1977 to 2013 and find that the differences in human capital and technology, which take into account the gap in capacity between the leader and follower countries, are the determinants that trigger the gross‐output‐enhancing effect of FDI. Our results are robust to the non‐linear effects, cyclical fluctuations, endogeneity of FDI per se, and the variation of the host countries' institutions and inflation.