Foreign direct investment and economic growth: an application of Markov switching model for Liberia

Abstract

This study models the long run effect of FDI on economic growth in Liberia using a two-regime fixed transition probabilities (FTP) Markov Switching Model (MSM). This model, which is advantageous in capturing asymmetry and persistence in extreme observations in the data, is applied to a yearly time series data set covering the period 1970-2012. During this period, the Liberian economy experienced major structural changes which may have imposed some asymmetric effects on macroeconomic variables. The results of the empirical analysis show that regime changes in Liberia are sudden and sporadic, with the economy remaining in the sustainable growth regime most of the time. FDI is positively related to growth when the economy is in the sustainable growth regime, and negatively related to growth when the economy is in the depressed growth regime. Given that the sustainable growth regime has a longer duration and lower probability of transitioning to the depressed growth regime, the study concludes that FDI has an overall positive impact on growth. Therefore, government policies that will encourage domestic resource mobilization (through savings, for example) and control inflation are recommended in attracting more FDI inflows to Liberia.