Foreign Direct Investment, Financial Markets and Economic

The empirical evidence is such that countries with better developed financial markets gain significantly from FDI. This paper formalizes the mechanism through which the trickle down effect of FDI depends on the extent of the development of the domestic financial sector. We model a small open economy with both foreign and domestic firms producing in the final good sector. Foreign and domestic firms compete for skilled and unskilled labor and intermediate products. Production of intermediate goods is carried out by entrepreneurs in a monopolistic market. To run a firm in the intermediate goods sector, entrepreneurs must first engage in R&D in order to develop a new variety of intermediate goods. Innovation, however, requires capital costs which must be financed through the domestic financial institutions. If the local financial markets are developed enough, they can allow credit constrained entrepreneurs to start their own firms. This not only spurs entrepreneurial activity but, more importantly, increases the number of varieties of intermediate goods which generate positive effects to the final good sector and allows the economy to benefit from the backward linkages between the foreign and domestic firms. Our calibration exercise shows that better financial markets allow an economy to take advantage of potential linkages from foreign to domestic firms: a 1% increase in FDI generates four times more growth for countries with deeper financial markets