Abstract
This article considers macro and welfare economic implications concerning foreign direct investment under a flexible exchange rate system. There are serious conflicts between foreign-invested firms and their home country as a whole. Although lower wages incentivize firms to obtain foreign direct investment, such a movement harms the welfare of the home-country’s economy in the following ways. First, an increase in unemployment in the home country worsens the economy’s welfare as proved by Otaki [1]. Second, an appreciation in the real exchange rate, which is induced by the transfer of earned profits in foreign countries to the home country, reduces the value of profits in terms of domestic goods. We prove that such an appreciation entirely cancels the benefit from the cost reduction that originates from the foreign direct investment in lower-wage countries. In the end, only the downturn in employment circumstance remains. In this sense, the glut of foreign direct investment is harmful and, some coordination is required between firms and the government of the home country.
Highlights
We prove that such an appreciation entirely cancels the benefit from the cost reduction that originates from the foreign direct investment in lower-wage countries
According to the neoclassical trade theory that deals with a barter economy under perfect competition, it seems natural and efficient for a higher-wage and capital-abundant country to export her real capital, such conventional wisdom cannot apply to a monetary economy in which idle resources are prevalent even if every price adjusts flexibly, as proved by Otaki [1,2,3]
We consider a small open economy under a flexible exchange rate system based on a standard two-periods overlapping generations (OLG) model
Summary
According to the neoclassical trade theory that deals with a barter economy under perfect competition, it seems natural and efficient for a higher-wage and capital-abundant country to export her real capital, such conventional wisdom cannot apply to a monetary economy in which idle resources ( labor forces) are prevalent even if every price adjusts flexibly, as proved by Otaki [1,2,3]. Hood and Young [6] and Caves [7] regard multi-national company as a device of internalizeing such firm-specific skills via economizing various transaction costs. These discussions stay in analyses concerning the behavior of each individual firm. Foreign direct investment causes serious conflicts between capital-exporting firms and their home country. Such conflicts come from the fact that the foreign direct investment deprives the home country of employment opportunities and reduces the effective demand in the home country.
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