Foreign Direct Investment, Exports & Aggregate Productivity

Empirical evidence confirms that trade exposure can shift resources towards the most efficient firms in an industry and induce substantial increases in aggregate productivity. Although recent studies document that much of world trade is controlled by multinational firms, few examine the effect of foreign direct investment decisions on resource allocation and aggregate productivity. This paper presents an open economy model where producers make simultaneous production and export decisions across different countries. In particular, the model highlights the interaction between firms’ location and export decisions and their effect on aggregate productivity. The theoretical model is estimated using detailed plant-level Indonesian manufacturing data. The results are broadly consistent with the pattern of productivity, exports and foreign investment across firms. I use the model to perform a number of counterfactual experiments to assess the effects of barriers to international trade and investment on aggregate productivity. The experiments suggest that there are substantial productivity gains due to international trade and investment. Moreover, they highlight that evaluating the substitutability and complementarity of trade and investment is crucial to determining the aggregate effects of international trade and foreign direct investment policy.