Foreign Direct Investment and Innovations: Transmission Dynamics of Persistent Demand and Technology Shocks in a Macro Model

A deeper macroeconomic analysis of foreign direct investment (FDI), innovation and other key variables is needed to better understand technology shock effects, transmission dynamics and policy perspectives in open economies. FDI outward stock relative to the source country total capital stock was above 10 percent in nine OECD countries in 2017, including the UK and the US. This paper adds FDI to a standard model with a tradable and a non-tradable sector. Here, we define non-tradable in a broad sense. The non-tradable sector covers those firms which are located in the tradable sector but undertake FDI in order to overcome the costs associated with exports but it also includes firms in the service industry who offer services which are intrinsically non-tradable, but which can be offered internationally via subsidiaries. This relates to traditional services (e.g., in retail) but also to novel digital services. We study how opening up the non-tradable sector to international transactions (via FDI) affects the international transmission of technology shocks and of persistent demand shocks. We consider a wide range of technology shocks differentiated by product and process innovations and by sectoral origin. Product innovations in formerly non-tradable sectors widen the scope in which innovations in one country can be transmitted abroad. One major difference between FDI and trade is the location of production, which induces different international income flows and requires upfront investment in the case of FDI. We show that this has implications for both the current account and the exchange rate. Process innovation in the tradable sector leads to a fall in the terms of trade (ToT) and a real appreciation of the exchange rate, expressed as the ratio between domestic and foreign consumer prices. The opposite sign is due to the Balassa-Samuelson effect. This pattern changes with a total factor productivity (TFP) shock in the non-tradable sector. Now, the ToT increases and the real exchange rate depreciates (aside from a short run appreciation). In the case of product innovations, both ToT and the real exchange rate (RER) behave similarly in both cases. However, the composition of the Current Account (CA) varies. With a process innovation in the export sector, both the trade balance and the primary income balance turn negative while product innovations in the FDI sector make the primary balance positive while the trade balance stays negative. We are especially interested in seeing whether the impulse responses to permanent shocks can tell us something about the reasons for persistent external imbalances in countries like Germany and the United States. For the US we find that product innovations originating from US multinationals, at least qualitatively matches well the negative current account and trade balance and a positive primary income balance. The German/Eurozone CA surplus is less easy to explain by technological factors since in our model all technology shocks are associated with persistent CA deficits. Our model confirms what has been shown in previous studies that the German CA is strongly driven by savings. We add to this the observation that increased savings also shows up in an improved primary income balance, which can indeed be observed for Germany.