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Foreign Direct Investment, Productive Capacity and Exchange Rate Regimes

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  • Joshua Aizenman

Abstract

The purpose of this paper is to examine the implications of foreign direct investment and endogenous capacity choice on the welfare ranking of exchange rate regimes, and to analyze the linkages between volatility of shocks, the volume of trade and investment. We construct an intertemporal version of a monopolistic competitive framework, where producers may diversify internationally by foreign direct investment. Volatility is shown to induce both higher international trade in goods, as well as higher foreign direct investment, with the possibility of increasing the productive capacity in diversified industries. We apply the above framework to the welfare ranking of exchange rate regimes in the presence of nominal contracts. We show that the volatility of employment in the presence of real shocks is lower under a floating exchange rate regime, but that a by-product of the relative stability of employment is a lower expected GNP in a flexible exchange rate regime. Nominal shocks in a floating exchange rate regime are shown to generate international diversification, which leads to a higher capital cost of diversified industries. This effect implies a lower number of? independent producers and of varieties offered, ultimately leading to a lower expected utility of consumption. We show that attempts to reduce foreign direct investment by capital controls will tend to reduce welfare, without affecting our results regarding the ranking of exchange rate regimes. These observations lead us to conclude that volatility effects reduce the relative attractiveness of floating exchange rates. This conclusion applies to both real and nominal shocks.

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Bibliographic Info

Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 3767.

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Date of creation: Jul 1991
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Publication status: published as Economica, 1994, Vol. 61, pp. 407-434 "Monetary & Real Shocks, Productive C Rate Regimes"
Handle: RePEc:nbr:nberwo:3767

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  1. Aizenman, Joshua, 1989. "Monopolistic competition, relative prices, and output adjustment in the open economy," Journal of International Money and Finance, Elsevier, Elsevier, vol. 8(1), pages 5-28, March.
  2. Fischer, Stanley, 1977. "Wage indexation and macroeconomics stability," Carnegie-Rochester Conference Series on Public Policy, Elsevier, Elsevier, vol. 5(1), pages 107-147, January.
  3. Richard C. Marston & Stephen J. Turnovsky, 1983. "Imported Materials Prices, Wage Policy, and Macroeconomic Stabilization," NBER Working Papers 1254, National Bureau of Economic Research, Inc.
  4. Richard Baldwin & Paul R. Krugman, 1986. "Persistent Trade Effects of Large Exchage Rate Shocks," NBER Working Papers 2017, National Bureau of Economic Research, Inc.
  5. Casella, Alessandra, 1992. "Participation in a Currency Union," American Economic Review, American Economic Association, American Economic Association, vol. 82(4), pages 847-63, September.
  6. Robert P. Flood & Nancy Peregrim Marion, 1980. "The Transmission of Disturbances under Alternative Exchange-Rate Regimeswith Optimal Indexing," NBER Working Papers 0500, National Bureau of Economic Research, Inc.
  7. Paul De Grauwe, 1988. "Exchange Rate Variability and the Slowdown in Growth of International Trade," IMF Staff Papers, Palgrave Macmillan, vol. 35(1), pages 63-84, March.
  8. Canzoneri, Matthew B & Rogers, Carol Ann, 1990. "Is the European Community an Optimal Currency Area? Optimal Taxation versus the Cost of Multiple Currencies," American Economic Review, American Economic Association, American Economic Association, vol. 80(3), pages 419-33, June.
  9. Lars E.O. Svensson & Sweder van Wijnbergen, 1987. "Excess Capacity, Monopolistic Competition, and International Transmission of Monetary Disturbances," NBER Working Papers 2262, National Bureau of Economic Research, Inc.
  10. Froot, Kenneth A & Stein, Jeremy C, 1991. "Exchange Rates and Foreign Direct Investment: An Imperfect Capital Markets Approach," The Quarterly Journal of Economics, MIT Press, MIT Press, vol. 106(4), pages 1191-217, November.
  11. Stephen J. Turnovsky, 1983. "Wage Indexation and Exchange Market Intervention in a Small Open Economy," NBER Working Papers 1170, National Bureau of Economic Research, Inc.
  12. Dixit, Avinash K, 1989. "Hysteresis, Import Penetration, and Exchange Rate Pass-Through," The Quarterly Journal of Economics, MIT Press, MIT Press, vol. 104(2), pages 205-28, May.
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Cited by:
  1. Charles van Marrewijk & Gus Garita, 2008. "Countries of a Feather flock together," Tinbergen Institute Discussion Papers, Tinbergen Institute 08-067/2, Tinbergen Institute, revised 19 Sep 2008.
  2. Joshua Aizenman, 1992. "Exchange Rate Flexibility, Volatility, and the Patterns of Domestic and Foreign Direct Investment," NBER Working Papers 3953, National Bureau of Economic Research, Inc.
  3. Atish R. Ghosh & Anne-Marie Gulde & Jonathan D. Ostry & Holger C. Wolf, 1997. "Does The Nominal Exchange Rate Regime Matter?," Working Papers, New York University, Leonard N. Stern School of Business, Department of Economics 97-09, New York University, Leonard N. Stern School of Business, Department of Economics.
  4. Joshua Aizenman, 1992. "Foreign Direct Investment as a Commitment Mechanism in the Presence of Managed Trade," NBER Working Papers 4102, National Bureau of Economic Research, Inc.
  5. repec:dgr:uvatin:2008067 is not listed on IDEAS

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