Foreign direct investments, environmental externalities and capital segmentation in a rural economy

- We examine the effects of FDI on a rural economy in a 2-sector model.
- FDI can enhance economic growth of the host country while damaging local environment.
- This can lead local agents to move from the local sector to the external sector.
- We study the dynamics and welfare effects of FDI emerging from the 2-sector model.
- We show under which conditions FDI can cause a welfare-reducing growth process.

This paper examines the possible effects of external investment inflows on the development of local rural economies, taking into account two recurrent features of many developing countries: capital market segmentation and environmental externalities. To investigate this issue, we examine a model with two sectors: the “local sector” and the “external sector”. Physical capital accumulation in the latter sector is driven by foreign direct investments, while in the former sector it follows a Solow-type accumulation mechanism. We assume that the production activity of the external sector damages the environment while the local sector relies on natural resources. In this context, we give the conditions under which capital inflows can promote diversification of host economy while improving welfare of local populations. If these conditions are not satisfied, external investments fuel a welfare reducing process (for the local community) and a self-enforcing growth of the external sector at the expense of the local one.