Causality Tests for Cross‐Country Panels: a New Look at FDI and Economic Growth in Developing Countries

Abstract

The remarkable increase in FDI flows to developing countries over the last decade has focused attention on whether this source of financing enhances overall economic growth. We use a mixed fixed and random (MFR) panel data estimation method to allow for cross country heterogeneity in the causal relationship between FDI and growth and contrast our findings with those from traditional approaches. We find that the relationship between investment, both foreign and domestic, and economic growth in developing countries is highly heterogeneous and that estimation methods which assume homogeneity across countries can yield misleading results. Our results suggest there is some evidence that the efficacy of FDI in raising future growth rates, although heterogeneous across countries, is higher in more open economies.