Foreign direct investment over the international business cycle

Among the G7 economies gross foreign direct investment (FDI) positions are very large, averaging 100% of GDP and dwarfing the absolute values of net FDI positions in most countries. Additionally, inward and outward FDI flows exhibit robust, positive correlation over the business cycle. In the standard international business cycle (IBC) model gross FDI stocks and flows are not well defined, and only net flows matter. We extend the standard model by allowing domestic and foreign ownership of physical capital in the aggregate production function to be imperfect substitutes. We estimate that elasticity of substitution using the co-movement of gross FDI flows, and find it to be less than 2.5 – a value much smaller than the implicitly assumed infinity in the IBC literature. Our results uncover a new source of welfare gains from openness to FDI among otherwise identical, developed economies – a capital diversity channel, akin to product variety in trade models. The channel is quantitatively important – openness to FDI yields steady-state welfare gains equivalent to at least a 4-5% increase in life-time consumption.