A Note on Foreign Capital, Economic Growth, and Convergence: A Simple Model with Endogenous Growth

Abstract

This paper examines the impact of foreign capital formation on economic growth in a simple modified model of endogenous growth. The model explicitly develops how proportional taxes on income can be used to finance government expenditures to attract foreign capital to the host nation. Another contribution of the model stems from showing how conditional convergence can be retained in the endogenous case via a hybrid model that includes foreign capital. The paper motivates the presentation of the model by discussing the potential positive (and negative) effects of inward foreign direct investment to developing economies and develops the supply and demand sides of the simple modified growth model. Also, the paper presents the transition dynamics towards the steady-state level of income under exogenous and endogenous growth and shows how conditional convergence can be retained in the hybrid model via a modified production function that converges asymptotically to the linear AK form, where A is a positive constant and K is physical capital. The paper suggests how the modified model can be used to motivate future empirical research, provided appropriate proxies are found for the variables and parameters of interest.