The Growth of FDI Relative to Trade: Measurement, Determinants, and Consequences of International Trade Flows in Intermediates

One of the most celebrated stylized facts in international economics over the past two decades is the growth of foreign direct investment (FDI) relative to trade and to world output. We explain the growth of FDI relative to trade using another highly celebrated fact – the growth in outsourcing of intermediate inputs. Using the United Nations’ Classification by Broad Economic Categories, we construct the first comprehensive panel data set of final and intermediate goods bilateral trade flows for 160 countries from 1990 to 2000. Motivated by a new general-equilibrium knowledge-and-physical-capital model with intermediates, we show that falling intermediates trade costs and subsequent outsourcing during this period explains a significant amount of the growth of FDI to trade, even after accounting for changes in investment and trade costs and in economic size and similarity. In deriving these results, we motivate a theoretical rationale for estimating gravity equations of bilateral final goods trade, intermediate goods trade, and FDI flows and for the observed higher value added per worker of multinational firms relative to national exporters