The Endogeneity of the Exchange Rate as a Determinant of FDI:
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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

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 FDI:(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) FDI:

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 FDI:

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 FDI:

  • 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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Key features of the model FDI:

  • 2 countries

  • Complete bond market

  • Risk-averse consumers

  • Sticky prices

  • Local sunk cost

  • Heterogeneous firms, as in Melitz (2003)


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Results FDI:

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 FDI:

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 FDI:

Effect of volatility on flows of FDI into Home country

positive/zero

negative

Shocks to Foreign money supply growth rate






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First-order conditions FDI:

Wage relation:

Money demand:

Consumption:


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First-order conditions and the real exchange rate FDI:

The bond-pricing equations

,

combine to provide an expression for the real exchange rate


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The nominal exchange rate FDI:

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 FDI:





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Aggregation I FDI:

where j = [H, F]




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The equilibrium distribution of productivity levels FDI:

Firms draw from g()

Profits are negative below (no entry)







Model calibration l.jpg
Model Calibration Home market



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Conclusions Home market

  • 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 Home market

  • 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 Home market

  • 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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Model Calibration Home market


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