Foreign Direct Investment in a Computable General Equilibrium Framework

Abstract

This paper develops a model of foreign direct investment (FDI) in a computable general equilibrium (CGE) framework by distinguishing between the activities of domestic and foreign-owned firms in both production and demand. Using a variant of the Armington assumption, the model is implemented by merging conventional production, demand and trade data with information on FDI. In a preliminary application, the model is used to analyze the Asia-Pacific Economic Cooperation goal of “free trade and investment in the region” by 2020. The model demonstrates that FDI matters; even in scenarios that do not liberalize FDI flows directly, FDI reinforces liberalization by making production more flexible. Trade and investment liberalization are generally complementary, in the sense that each strengthens the other linkage. Because FDI offers access to foreign technology and variety even in non-traded sectors, its economic effects are particularly pronounced in services.