Investment Creation and Real Exchange Rates in a Model with Search Frictions

Abstract

Foreign Investment is modeled as the outcome of a search process that emphasizes the distinction between investment creation and investment destruction processes which underlie net flows. The optimal q is shown to equal the difference between a naive net present value calculation and the call option of further search. The investment mechanism is embedded in a two-sector dynamic small open-economy model to derive the response of the economy to a capital market liberalization. The presence of an option value to search is shown to generate dynamics in investment inflows, which when combined with the saving-production decisions of households, generates co-movement in real exchange rates, consumption, current account deficits and non-traded sector output which closely resembles the experience of several Latin-American countries, starting in the late nineteen eighties. The search approach to investment contrasts with the standard q-theory approach which generates counterfactual predictions in this framework. Lastly, the paper evaluates the effect of cyclical shocks on direct investment decisions and provides an argument for the observed stability of these flows.