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Capital Flow, Foreign Direct Investment and Home Market Effect


  • Naohisa Hirakata

    (Director and Senior Economist, Institute for Monetary and Economic Studies (currently, Financial System and Bank Examination Department), Bank of Japan (E-mail:

  • Mitsuru Katagiri

    (Associate Director and Economist, Institute for Monetary and Economic Studies (currently, Monetary Affairs Department), Bank of Japan (E-mail:


In this paper, we investigate the dynamics of foreign direct investment (FDI) and examine the effects of FDI on the macroeconomic dynamics following a decline in labor endowment. In so doing, we introduce capital accumulation into Helpman, Melitz and Yeaple (2004)'s model and extend their model to a dynamic setting following Ghironi and Melitz (2005). Our main findings are as follows. First, we find that FDI stocks do not monotonically decrease toward the new steady state but rather initially increase and move away from the new steady state before reversing course and converging to it, reflecting the fact that a part of foreign assets is accumulated in the form of FDI. Second, we find that foreign portfolio investment (FPI) helps the funding of foreign multinational firms and encourages inward FDI by them. While the increase in inward FDI decreases the number of domestic firms by discouraging their entry, it increases the equilibrium relative wages, thus making the relationship between relative wages and the number of firms different from the conventional "home market effect.''

Suggested Citation

  • Naohisa Hirakata & Mitsuru Katagiri, 2013. "Capital Flow, Foreign Direct Investment and Home Market Effect," IMES Discussion Paper Series 13-E-05, Institute for Monetary and Economic Studies, Bank of Japan.
  • Handle: RePEc:ime:imedps:13-e-05

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    References listed on IDEAS

    1. Markusen, James R. & Venables, Anthony J., 2000. "The theory of endowment, intra-industry and multi-national trade," Journal of International Economics, Elsevier, vol. 52(2), pages 209-234, December.
    2. Hsieh, Chang-Tai & Ossa, Ralph, 2016. "A global view of productivity growth in China," Journal of International Economics, Elsevier, vol. 102(C), pages 209-224.
    3. Brainard, S Lael, 1997. "An Empirical Assessment of the Proximity-Concentration Trade-off between Multinational Sales and Trade," American Economic Review, American Economic Association, vol. 87(4), pages 520-544, September.
    4. Backus, David K & Kehoe, Patrick J & Kydland, Finn E, 1992. "International Real Business Cycles," Journal of Political Economy, University of Chicago Press, vol. 100(4), pages 745-775, August.
    5. Marc J. Melitz, 2003. "The Impact of Trade on Intra-Industry Reallocations and Aggregate Industry Productivity," Econometrica, Econometric Society, vol. 71(6), pages 1695-1725, November.
    6. Natalia Ramondo & Andrés Rodríguez-Clare, 2010. "Growth, Size, and Openness: A Quantitative Approach," American Economic Review, American Economic Association, vol. 100(2), pages 62-67, May.
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    More about this item


    Foreign Direct Investment (FDI); Capital Flows; Home Market Effect;

    JEL classification:

    • F12 - International Economics - - Trade - - - Models of Trade with Imperfect Competition and Scale Economies; Fragmentation
    • F23 - International Economics - - International Factor Movements and International Business - - - Multinational Firms; International Business
    • F32 - International Economics - - International Finance - - - Current Account Adjustment; Short-term Capital Movements

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