The Endogeneity of the Exchange Rate as a Determinant of FDI: A Model of Money, Entry, and Multinati

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The Endogeneity of the Exchange Rate as a
Determinant of FDIA Model of Money, Entry, and
Multinational Firms

• Katheryn Niles Russ
• University of California, Davis

Seminar presentation for the Federal Reserve Bank
of Kansas City
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Does exchange rate volatility deter FDI? (theory)
No
Yes

• Risk-averse investors (Goldberg and Kolstad
  1995, Cushman 1985 and 1988)
• Option value (Rivoli and Salorio 1996, Campa
  1993)
• Prevents use of FDI as hedging device
  (Aizenman 1992)

• FDI is a substitute for trade (Mundell
  1957, Goldberg and Kolstad 1995, Cushman 1985 and
  1989)
• Encourages use of FDI as hedging device
  (Negishi 1985, Sung and Lapan 2000)

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Does exchange rate volatility deter FDI?
(empirics)
No
Yes

• Campa (1993)
• Amuedo-Dorantes and Pozo (2001)
• Chakrabarti and Scholnick (2002)
• Galgau and Sekkat (2004)

• Cushman (1985 and 1989)
• Goldberg and Kolstad (1995)
• Zhang (2003)
• Galgau and Sekkat (2004)

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The missing link

• Exchange rate movements may be influenced by the
  same underlying variables as sales abroad.
• Precedent Aizenman 1992, Goldberg and Kolstad
  1995

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A macro look

• Link exchange rate movements to monetary
  variables.
• Existing models of FDI with endogenous exchange
  rates Aizenman 1992, 1994 Devereux and
  Engel 2001

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Global map
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Key features of the model

• 2 countries
• Complete bond market
• Risk-averse consumers
• Sticky prices
• Local sunk cost
• Heterogeneous firms, as in Melitz (2003)

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Results

• The relationship between exchange rate volatility
  and foreign direct investment depends on the
  source of the volatility.

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Shocks to Home money supply growth rate

• Correlation between sales at Home and value of
  Home currency
• Effect of volatility on flows of FDI into Home
  country

• negative
• positive

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Shocks to Foreign money supply growth rate

• Correlation between sales at Home and value of
  Home currency
• Effect of volatility on flows of FDI into Home
  country

• positive/zero
• negative

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Special case
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The consumers problem
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The Home price index and demand functions
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Money-supply growth process
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First-order conditions
Wage relation
Money demand
Consumption
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First-order conditions and the real exchange rate
The bond-pricing equations
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combine to provide an expression for the real
exchange rate
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The nominal exchange rate
Substitute the first-order condition for money
demand from both the Home and the Foreign
consumers problem with the expression for the
real exchange rate
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Timeline
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Technology
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The firms problem
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Pricing rules
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Aggregation I
where j H, F
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Aggregation II
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The aggregate price level in the open economy
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The equilibrium distribution of productivity
levels
Firms draw from g( )
Profits are negative below (no entry)
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Probability density of labor productivity in the
Home economy
0
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Equilibrium the zero-cutoff profit conditions
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The threshold productivity levels
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Geographic preference When is ?
and
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The relative difficulty faced by Foreign firms
entering the Home market
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Model Calibration
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Productivity shocks and active monetary policy
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Conclusions

• Exchange-rate variability can mitigate the
  effects of uncertainty in the host-country money
  supply on FDI (supports Hausmann and
  Fernandez-Arias 2000), encouraging FDI.
• Monetary volatility in a firms native market
  introduces exchange rate risk without offsetting
  effects on sales, deterring FDI.

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Conclusions

• Aggregate productivity can be influenced by
  fundamental variables, even if available
  technology does not change (DFS 1977, Melitz
  2003).
• PTM may not insulate an economy from foreign
  monetary shocks.

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Further questions

• Productivity shocks, optimal monetary policy
• Vertical FDI, trade (Aizenman and Marion 2004)
• Introduction of physical capital
• Business cycle ramifications of MNEs
• Allowing for geographic preference

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The average productivity level
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The threshold productivity levels
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Model Calibration
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