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Exchange Rates and FDI: Goods versus Capital Market Frictions

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  • Claudia M. Buch
  • Jörn Kleinert

Abstract

ABSTRACT Changes in exchange rates affect countries through their impact on cross-border activities such as trade and foreign direct investment (FDI). With increasing activities of multinational firms, the FDI channel is likely to gain in importance. Economic theory provides two main explanations why changes in exchange rates can affect FDI. According to the first explanation, FDI reacts to exchange rate changes if there are information frictions on capital markets and if investment depends on firms' net worth (capital market friction hypothesis). According to the second explanation, FDI reacts to exchange rate changes if output and factor markets are segmented, and if firm-specific assets are important (goods market friction hypothesis). We provide a unified theoretical framework of these two explanations. We analyse the implications of the model empirically using a dataset based on detailed German firm-level data. We find greater support for the goods market than for the capital market friction hypothesis. Copyright 2008 The Authors. Journal compilation 2008 Blackwell Publishing Ltd.

Suggested Citation

  • Claudia M. Buch & Jörn Kleinert, 2008. "Exchange Rates and FDI: Goods versus Capital Market Frictions," The World Economy, Wiley Blackwell, vol. 31(9), pages 1185-1207, September.
  • Handle: RePEc:bla:worlde:v:31:y:2008:i:9:p:1185-1207
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    References listed on IDEAS

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    1. Klein, Michael W. & Rosengren, Eric, 1994. "The real exchange rate and foreign direct investment in the United States : Relative wealth vs. relative wage effects," Journal of International Economics, Elsevier, vol. 36(3-4), pages 373-389, May.
    2. Russ, Katheryn Niles, 2007. "The endogeneity of the exchange rate as a determinant of FDI: A model of entry and multinational firms," Journal of International Economics, Elsevier, vol. 71(2), pages 344-372, April.
    3. Rajan, Raghuram G & Zingales, Luigi, 1998. "Financial Dependence and Growth," American Economic Review, American Economic Association, vol. 88(3), pages 559-586, June.
    4. Blonigen, Bruce A, 1997. "Firm-Specific Assets and the Link between Exchange Rates and Foreign Direct Investment," American Economic Review, American Economic Association, vol. 87(3), pages 447-465, June.
    5. Kenneth A. Froot & Jeremy C. Stein, 1991. "Exchange Rates and Foreign Direct Investment: An Imperfect Capital Markets Approach," The Quarterly Journal of Economics, Oxford University Press, vol. 106(4), pages 1191-1217.
    6. Fosfuri, Andrea & Motta, Massimo, 1999. " Multinationals without Advantages," Scandinavian Journal of Economics, Wiley Blackwell, vol. 101(4), pages 617-630, December.
    7. Cushman, David O, 1985. "Real Exchange Rate Risk, Expectations, and the Level of Direct Investment," The Review of Economics and Statistics, MIT Press, vol. 67(2), pages 297-308, May.
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    Cited by:

    1. Takagi, Shinji & Shi, Zongying, 2011. "Exchange rate movements and foreign direct investment (FDI): Japanese investment in Asia, 1987–2008," Japan and the World Economy, Elsevier, vol. 23(4), pages 265-272.
    2. Guo, Yan, 2013. "Strategic trade policy, cost uncertainty and FDI determinants," ISU General Staff Papers 201301010800004464, Iowa State University, Department of Economics.
    3. Jung Wan Lee, 2015. "Dynamic Relationships between Exchange Rates and Foreign Direct Investment: Empirical Evidence from Korea," Asian Economic Journal, East Asian Economic Association, vol. 29(1), pages 73-90, March.
    4. Aray, Henry & Gardeazabal, Javier, 2010. "Going multinational under exchange rate uncertainty," Journal of International Money and Finance, Elsevier, vol. 29(6), pages 1171-1191, October.
    5. Matthias Busse & Carsten Hefeker & Signe Nelgen, 2013. "Foreign Direct Investment and Exchange Rate Regimes," Economics Bulletin, AccessEcon, vol. 33(1), pages 843-858.
    6. Works, Richard Floyd, 2016. "Econometric modeling of exchange rate determinants by market classification: An empirical analysis of Japan and South Korea using the sticky-price monetary theory," MPRA Paper 76382, University Library of Munich, Germany.
    7. repec:blg:reveco:v:69:y:2017:i:3:p:85-93 is not listed on IDEAS
    8. Adugna Olani, 2016. "Dynamic Capital inflow transmission of monetary policy to emerging markets," Working Papers 1358, Queen's University, Department of Economics.
    9. Lord Mensah & Godfred Alufar Bokpin & Eric Dei Fosu-Hene, 2017. "Foreign exchange rate moments and FDI in Ghana," Journal of Economics and Finance, Springer;Academy of Economics and Finance, vol. 41(1), pages 136-152, January.

    More about this item

    JEL classification:

    • F31 - International Economics - - International Finance - - - Foreign Exchange
    • F23 - International Economics - - International Factor Movements and International Business - - - Multinational Firms; International Business
    • F21 - International Economics - - International Factor Movements and International Business - - - International Investment; Long-Term Capital Movements

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