ChainWhat it assumes · how to break it
Start
Multinationals invest in new factories, mines and offices in an emerging economy, attracted by low labour costs and a growing market.
1
As a result, investment, a component of AD, rises, and through the multiplier real GDP rises by more than the initial spending.
aggregate demand · multiplier
aggregate demand · multiplier
Assumes: The FDI is new investment that adds to spending.
But: If the multinational simply buys an existing local firm, there is a change of ownership and little new spending.
2
At the same time, the economy's capital stock grows without relying on domestic savings, which are low in many developing countries.
savings gap · Harrod–Domar model
savings gap · Harrod–Domar model
Assumes: Lack of domestic savings is what holds back investment.
But: The binding constraint may instead be poor infrastructure, weak institutions or a shortage of skilled labour.
3
In addition, local workers and firms learn new production methods, management techniques and technology from the multinational, raising productivity.
technology transfer · productivity
technology transfer · productivity
Best link to attack
Assumes: Knowledge spreads from the multinational to local workers and firms.
Assumes: Knowledge spreads from the multinational to local workers and firms.
But: Multinationals often keep research and skilled work at home and employ local staff in routine tasks, so little technology is transferred.
4
Therefore, LRAS shifts right, raising the productive potential of the economy so that higher growth can be sustained without inflation.
long-run aggregate supply · potential growth
long-run aggregate supply · potential growth
Assumes: The gains in capital and productivity last.
But: If the investment is footloose and leaves when wages rise, the gain in capacity is lost.
End
Actual growth rises through higher AD, and potential growth rises as the capital stock and productivity increase.
Evaluation chain
- E1However, the long-run growth benefit depends on whether technology and skills actually spread from the multinational to local firms.
- E2If the multinational employs local workers only in low-skilled assembly and imports its technology ready-made, local firms learn little.
- E3As a result, productivity in the rest of the economy barely changes and LRAS shifts by little beyond the plant's own capacity.
- E4So FDI may give a short boost to AD without raising long-run growth much, unless the country has the education and skills to absorb the new technology.
Another way to attack it: Profits made by the multinational are often repatriated, so GNI rises by less than GDP and less of the income is reinvested in the host economy.
The AD effect comes during construction; the productivity gains from technology transfer take years to spread.
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Questions this answers
- Evaluate the extent to which FDI promotes economic growth in developing countries.
- Assess the benefits to an emerging economy of attracting multinational companies.
- Explain how foreign direct investment could increase a country's productive potential.
Diagram
AD/AS: AD shifts right (investment) and LRAS shifts right (capital and productivity), so real output rises with little pressure on the price level.
Reverse and related
Fall in FDI → lower investment and less technology transfer, so both actual and potential growth slow.