Foreign direct investment and spillovers: gradualism may be better
The standard argument says that in the presence of positive spillovers foreign direct investment should be promoted and subsidized. In contrast, this paper claims that the very existence of spillovers may require temporarily restricting FDI. Our argument is based on two features of spillovers: they are limited by the economy's absorptive capacity and they take time to materialize. By letting in capital more gradually, initial investment has the time to create spillovers – and upgrade the economy's absorptive capacity – before further investment occurs. The economy converges to a steady state with a superior technology and a greater capital stock.