Exchange Rate Flexibility, Volatility, and the Patterns of Domestic and Foreign Direct Investment

Abstract

The goal of this paper is to investigate the factors determining the impact of exchange rate regimes on the behavior of domestic investment and foreign direct investment (FDI), and the correlation between exchange rate volatility and investment. We assume that producers may diversify internationally in order to increase the flexibility of production: being a multinational enables producers to reallocate employment and production towards the more efficient or the cheaper plant. We characterize the possible equilibria in a macro model that allows for the presence of a short-run Phillips curve, under a fixed and a flexible exchange rate regime. It is shown that a fixed exchange rate regime is more conducive to FDI relative to a flexible exchange rate, and this conclusion applies for both real and nominal shocks. The correlation between investment and exchange rate volatility under a flexible exchange rate is shown to depend on the nature of the shocks. If the dominant shocks are nominal, we will observe a negative correlation, whereas if the dominant shocks are real, we will observe a positive correlation between exchange rate volatility and the level of investment.