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The Endogeneity of the Exchange Rate as a Determinant of FDI: A Model of Money, Entry, and Multinational Firms Katheryn Niles Russ University of California, Davis Seminar presentation for the Federal Reserve Bank of Kansas City

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The Endogeneity of the Exchange Rate as a Determinant of FDI: A Model of Money, Entry, and Multinational Firms

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The Endogeneity of the Exchange Rate as a Determinant of FDI:A Model of Money, Entry, and Multinational Firms

Katheryn Niles Russ

University of California, Davis

Seminar presentation for the

Federal Reserve Bank of Kansas City


Does exchange rate volatility deter fdi theory l.jpg

Risk-averse investors (Goldberg and Kolstad 1995, Cushman 1985 and 1988)

“Option value” (Rivoli and Salorio 1996, Campa 1993)

Prevents use of FDI as hedging device (Aizenman 1992)

FDI is a substitute for trade(Mundell 1957, Goldberg and Kolstad 1995, Cushman 1985 and 1989)

Encourages use of FDI as hedging device(Negishi 1985, Sung and Lapan 2000)

Does exchange rate volatility deter FDI? (theory)

Yes

No


Does exchange rate volatility deter fdi empirics l.jpg

Campa (1993)

Amuedo-Dorantes and Pozo (2001)

Chakrabarti and Scholnick (2002)

Galgau and Sekkat (2004)

Cushman (1985 and 1989)

Goldberg and Kolstad (1995)

Zhang (2003)

Galgau and Sekkat (2004)

Does exchange rate volatility deter FDI? (empirics)

Yes

No


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The missing link

Exchange rate movements may be influenced by the same underlying variables as sales abroad.

Precedent: Aizenman 1992, Goldberg and Kolstad 1995


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A macro look

  • Link exchange rate movements to monetary variables.

  • Existing models of FDI with endogenous exchange rates: Aizenman 1992, 1994 Devereux and Engel 2001


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Global map


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Key features of the model

  • 2 countries

  • Complete bond market

  • Risk-averse consumers

  • Sticky prices

  • Local sunk cost

  • Heterogeneous firms, as in Melitz (2003)


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Results

The relationship between exchange rate volatility and foreign direct investment depends on the source of the volatility.


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Correlation between sales at Home and value of Home currency

Effect of volatility on flows of FDI into Home country

negative

positive

Shocks to Home money supply growth rate


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Correlation between sales at Home and value of Home currency

Effect of volatility on flows of FDI into Home country

positive/zero

negative

Shocks to Foreign money supply growth rate


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Special case


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The consumer’s problem


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The Home price index and demand functions


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Money-supply growth process


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First-order conditions

Wage relation:

Money demand:

Consumption:


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First-order conditions and the real exchange rate

The bond-pricing equations

,

combine to provide an expression for the real exchange rate


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The nominal exchange rate

Substitute the first-order condition for money

demand from both the Home and the Foreign

consumer’s problem with the expression for the

real exchange rate:


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Timeline


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Technology


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The firm’s problem


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Pricing rules


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Aggregation I

where j = [H, F]


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Aggregation II


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The aggregate price level in the open economy


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The equilibrium distribution of productivity levels

Firms draw from g()

Profits are negative below (no entry)


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Probability density of labor productivity in the Home economy

0


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Equilibrium: the zero-cutoff profit conditions


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The threshold productivity levels


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Geographic preference: When is ?

and


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The relative difficulty faced by Foreign firms entering the Home market


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Model Calibration


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Productivity shocks and active monetary policy


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Conclusions

  • Exchange-rate variability can mitigate the effects of uncertainty in the host-country money supply on FDI (supports Hausmann and Fernandez-Arias 2000), encouraging FDI.

  • Monetary volatility in a firm’s native market introduces exchange rate risk without offsetting effects on sales, deterring FDI.


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Conclusions

  • Aggregate productivity can be influenced by fundamental variables, even if available technology does not change (DFS 1977, Melitz 2003).

  • PTM may not insulate an economy from foreign monetary shocks.


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Further questions

  • Productivity shocks, optimal monetary policy

  • Vertical FDI, trade (Aizenman and Marion 2004)

  • Introduction of physical capital

  • Business cycle ramifications of MNEs

  • Allowing for geographic preference


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The average productivity level


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The threshold productivity levels


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Model Calibration


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