SM2206 – Applied Econometrics

Individual Assignment. Due: 24th April 2022

Ahmad Zawawi Bin Mohd. Abihu Rairah. (B20200171)

A Panel Model of Inflation and Foreign Direct Investment (FDI) based on data from Guyana, Brunei
Darussalam, Jamaica, Japan, and Germany.

INTRODUCTION

Foreign Direct Investment (FDI) is seen as critical in developing countries because it allows for economic
growth by increasing demand for local currency and allowing for spillover effects of technological
advancement and human capital. Using panel data from OECD nations, a previous study discovered that
investments are highly sensitive to inflation rates and that they have a negative relationship.
(Madsen,2003). Another study done by Sayek.S in 2009 also show similar results using different data.
The objective of this paper is to look at the relationship between inflation and foreign direct investment
and see if previous findings can be replicated using a different data set and model.

METHODOLOGY AND DATA DESCRIPTION

The dataset includes data from Guyana, Brunei Jamaica Japan, and Germany with 16 observations from
each country for inflation rate and FDI in US dollars (USD) (source: https://data.worldbank.org).

Figure 1: Inflation Rate Figure 2: FDI in US Dollars (USD)

Figure 1 shows that Jamaica has the highest average inflation rate among the countries, whereas Figure
2 shows that Germany and Japan have more FDI than the others.
This paper uses the discrete growth rate of both inflation rate and FDI as unit root tests shows that both
inflation rate and FDI are non-stationary. The discrete growth rate of FDI is regressed against the discrete
growth rate of inflation. To capture other possible effects, the product of both the discrete growth rate of
FDI and inflation rate are included as additional explanatory variables. Below shows the panel model for
analysis.

(G_FDI)t = α + β1(G_INF)t + β2(G_INF*G_FDI)t + εt (1)

Where G_FDIt and G_INFt are the discrete growth rate of FDI and discrete growth rate of inflation rate at
time t, respectively, and εt is the random error.

Table 1. Descriptive Statistics:

Discrete growth rate of Discrete growth rate of

Inflation Rate Foreign Direct Investment (FDI)
Mean 0.20 0.23
Maximum 30.59 18.47
Minimum -8.60 -10.02
Std. Dev. 4.06 2.70
Skewness 5.59 3.58
Kurtosis 43.6 31.88

Both data sets have positive skewness, which means they are skewed in the same direction that is to the
right. Both data sets have experienced negative growth and the mean discrete growth rate differs only
little.
Figure 3: Discrete growth rate of FDI Figure 4: Discrete growth rate of inflation rate
RESULTS

Table 2. Panel Unit Root Test Results

Levin, Lin & Chu* Im, Pesaran and Shin ADF – Fischer PP-Fischer Chi-
W-stat Chi-Square Square
Discrete growth
rate of Inflation 0.0006 0.0099 0.0105 0.0000
Rate
Discrete growth
rate of FDI 0.0007 0.0105 0.0184 0.0003

Unit root tests confirm that all series used in the panel model are stationary as shown in table 2. The model
depicted as Equation 1 is presented in the following table.

Table 3. Panel Model of discrete growth rate of FDI and discrete growth rate of Inflation Rate.

Variable Coefficient Std. Error t-Statistics Prob.

Discrete growth rate of Inflation rate 0.317 0.0490 0.648 0.5191
(Discrete growth rate of Inflation rate *
Discrete growth rate of FDI) -0.118 0.011 -11.1 0.00
C -0.005 0.191 0.0273 0.978
Dependent variable: Discrete growth rate of FDI, Adj R2 = 63.5%

Table 4. Redundant Fixed Effect Tests.

Effect Test: Probability:

Cross-section F 0.6992
Cross-section Chi-square 0.5579
Period F 0.9665
Period Chi-square 0.9128
Cross-Section/Period F 0.9732
Cross-Section/Period Chi-square 0.9274
Fixed effects redundancy tests for cross-section, period and joint cross-section-period are insignificant,
therefore dummy variables do not add any new information and fixed effects are redundant. This means
that the constant coefficient model is the better approach.

Table 3 shows that the product of discrete growth of inflation rate and the discrete growth rate of FDI is
significant in explaining the discrete growth rate of FDI. The discrete growth rate of inflation however is
insignificant in explaining the discrete growth rate of FDI.

Conclusion

This paper examines how discrete growth rate of inflation rate affects the discrete growth rate of FDI. The
analysis which is based on panel data with 80 observations of FDI in US dollars and Inflation rates from
Guyana, Brunei, Jamaica, Japan and Germany shows that discrete growth rate of FDI has a negative
relationship with the product of the two series used in the panel model. The Panel model reveals that a
change in discrete growth of FDI is equal to -0.118*change in discrete growth rate of inflation*discrete
growth rate in FDI. This model fails to show any concrete evidence of whether inflation rate and FDI are
positively or negatively related using the data from the five countries, Madsen in 2003 used panel data of
OECD countries from the year 1982 to 1999 and Sayek. S in 2009 where their papers shows that there is
they have a negative relationship. However, the model suggests that any change in discrete growth rate in
inflation causes a reduction in discrete growth rate of Foreign Direct Investment (FDI).

References:

Madsen, J. B. (2003). Inflation and investment. Scottish Journal of Political Economy, 50(4), 375-397.

Sayek, S. (2009). Foreign direct investment and inflation. Southern Economic Journal, 76(2), 419-443.