Journal of Development Economics 43 (1994) 295-315. North-Holland A prototype macroeconomic model of foreign direct investment Jim Malley and Thomas Moutos* University of Stirling, zyxwvutsrqponmlkjihgfedcbaZYXWVUTSRQPONMLKJIHGFE Stirling, UK Received October 1991, final version received February 1993 This paper constructs a prototype macroeconomic model of a small open economy which is a recipient of foreign direct investment. Foreign firms invest in the domestic economy in order to take advantage of lower wage costs. The rate at which such investment takes place is determined by the time that elapses between development of new products in the rest of the world and the acquisition of knowledge by the domestic labour force for producing those products. The model is used to investigate the effects of policy measures and of changes in the rates of innovation and technology transfer on the main macroeconomic variables. Key words: Multinational corporations; Foreign direct investment; Product innovation; Techno- logy transfer JEL classification: F21, F41, 011 1. Introduction Despite the increasing importance of multinational corporations (MNCs) and of foreign direct investment (FDI) in the world economy,‘there has been no attempt to integrate these phenomena into an explicitly macroeco- nomic framework. The standard literature on international trade and invest- ment [see, for example, MacDougall (1960), Jones (1967) Kemp (1969), Batra and Ramachandran (1980), Bhagwati and Srinivasan (1983)] has been concerned with the causes and consequences of a once-and-for-all realloca- tion of physical capital from one country to another. Moreover, the models presented in these papers assume inelastic factor supplies and full employ- Correspondence ro: J. Malley, Department of Economics, University of Stirling, Stirling FK9 4LA, Scotland, U.K. *An earlier version of this paper has been presented in seminars at the Universities of Aberdeen, Dundee, Glasgow, and Strathclyde. We would like to thank the seminar participants and Bob Hart, Hassan Molana and Robin Ruffell for useful comments. We would also like to thank participants at the Royal Economic Society Conference, London, March 1992 for helpful suggestions. Finally we would like thank two (anonymous) referees whose comments have greatly improved the presentation of the paper. The usual disclaimer applies. ‘In the tive years to 1989 the flow of FDI in the world economy rose at an annual rate of 2Yj/,, which is three times faster than the growth in world trade [UNTC (1991). 0304-3878/94/$07.00 6 1994 Elsevier Science B.V. All rights reserved SSDI 0304-3878(93)EOO47-2