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

1. 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

4. 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

5. 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

6. The missing link Exchange rate movements may be influenced by the same underlying variables as sales abroad. Precedent: Aizenman 1992, Goldberg and Kolstad 1995

7. 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

8. Global map

9. Key features of the model • 2 countries • Complete bond market • Risk-averse consumers • Sticky prices • Local sunk cost • Heterogeneous firms, as in Melitz (2003)

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

11. 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

12. 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

13. Special case

14. The consumer’s problem

15. The Home price index and demand functions

16. Money-supply growth process

17. First-order conditions Wage relation: Money demand: Consumption:

18. First-order conditions and the real exchange rate The bond-pricing equations , combine to provide an expression for the real exchange rate

19. 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:

20. Timeline

21. Technology

22. The firm’s problem

23. Pricing rules

24. Aggregation I where j = [H, F]

25. Aggregation II

26. The aggregate price level in the open economy

27. The equilibrium distribution of productivity levels Firms draw from g() Profits are negative below (no entry)

28. Probability density of labor productivity in the Home economy 0

29. Equilibrium: the zero-cutoff profit conditions

30. The threshold productivity levels

31. Geographic preference: When is ? and

32. The relative difficulty faced by Foreign firms entering the Home market

33. Model Calibration

40. Productivity shocks and active monetary policy

41. 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.

42. 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.

43. 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

44. The average productivity level

47. The threshold productivity levels

48. Model Calibration