Monetary and Real Shocks, Productive Capacity and Exchange Rate Regimes

Abstract

where producers may diversify internationally. International diversification is shown to inuuce a positive correlation between the volatility of productivity shocks and investment. In the presence of a Phillips curve, the expected GNP is lower under a floating exchange rate regime than under a fixed exchange rate regime. This result applies both for real and monetary shocks. Attempts to reduce foreign direct investment by capital controls will tend to reduce welfare, without affecting our results regarding the ranking of exchange rate regimes. implies that, in the presence of market power, uncertainty tends to reduce investment. In the first part of the paper I demonstrate the international diversi- fication of production modifies this result. Foreign direct investment tends to offset the impact of market power on the concavity of the profit function, by weakening the relative price effect associated with output changes, and by increasing the flexibility of adjusting the variable input. Hence international diversification of production is shown to induce a positive correlation between the volatility of productivity shocks and investment. The second part of the paper utilizes the framework presented in Section I to re-examine the welfare ranking of exchange rate regimes in the presence of capital mobility. As is well appreciated, a one-dimensional answer regarding the merits of a fixed exchange rate regime will not do justice to the host of issues relevant for making the choice between exchange rate regimes. The second part of the paper focuses on one aspect of the debate: the linkages between volatility, domestic and foreign direct investment, and productive capacity. A frequent argument in favour of exchange rate stability relates to the potential cost of exchange rate volatility, which may work to increase the cost of international trade and to reduce its volume. Yet efforts to detect the adverse effects of exchange rate volatility on trade volumes in the last two decades have not delivered clear-cut results. In fact, the experience of international trade among the United States, Canada, Europe and Japan suggests that there is no natural