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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.

Suggested Citation

  • Joshua Aizenman, 1991. "Foreign Direct Investment, Productive Capacity and Exchange Rate Regimes," NBER Working Papers 3767, National Bureau of Economic Research, Inc.
  • Handle: RePEc:nbr:nberwo:3767
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    Cited by:

    1. Mr. Jonathan David Ostry & Ms. Anne Marie Gulde & Mr. Atish R. Ghosh & Holger C. Wolf, 1995. "Does the Nominal Exchange Rate Regime Matter?," IMF Working Papers 1995/121, International Monetary Fund.
    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. Charles van Marrewijk & Gus Garita, 2008. "Countries of a Feather flock together," Tinbergen Institute Discussion Papers 08-067/2, Tinbergen Institute, revised 19 Sep 2008.
    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. Zainab Jehan & Azooba Hamid, 2017. "Exchange rate volatility and capital inflows: role of financial development," Portuguese Economic Journal, Springer;Instituto Superior de Economia e Gestao, vol. 16(3), pages 189-203, December.
    6. Guglielmo Maria Caporale & Thouraya Hadj Amor & Christophe Rault, 2014. "Sources Of Real Exchange Rate Volatility And International Financial Integration: A Dynamic Generalised Method Of Moments Panel Approach," Journal of International Development, John Wiley & Sons, Ltd., vol. 26(6), pages 810-820, August.

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