EXCHANGE RATE CHANGES, INFLATION, AND THE VALUE OF THE MULTINATIONAL CORPORATION

Abstract

THE EFFECTS of differing national rates of inflation and exchange rate changes on the profitability and hence the risk of multinational corporations is currently receiving much attention from both the management of these firms and the accounting profession. In addition, the relationships between changes in currency values, both internal and external, and the international investing, trading, production, and marketing decisions of multinational firms are clearly of great interest to the national governments involved. This paper, with the aid of a two-country model, first focuses on the profitability issue. It then characterizes and analyzes an oligopolistic firm's binational profit-maximizing strategy under inflation and devaluation. The latter work draws heavily on Horst's [14] detailed examination of the effects of differing national tax and tariff rates on the profit-maximizing strategy of a firm selling to two national markets simultaneously. The unit of analysis here is the overseas subsidiary of an oligopolistic multinational corporation' which sells its (the subsidiary's) output both locally (country 1) and abroad (country 2). Country 1 is subject to both inflation and devaluation while country 2's price level and exchange rate are assumed to remain constant throughout this paper. Initially, production will be limited to country 1. The effects of relaxing this restriction to permit production in both countries will be analyzed later on. The results arrived at for a devaluation would be reversed for a revaluation. Accounting practice and economic theory are shown to diverge widely in their implications regarding the effects of these exchange rate changes. Most accountants and firms take a approach in defining their exposure to exchange rate changes. This approach assumes that only financial items on the current balance sheet whose dollar (or some other base currency) value will be adversely affected by a devaluation are