The Behavior of an Open-Economy Firm under Flexible Exchange Rates

Abstract

Most proponents and opponents of floating believe that greater variability of foreign exchange rates will increase uncertainty in international transactions and, hence, that the volume of international trade and financial flows will be curtailed without well-developed facilities for hedging against exchange uncertainty. The effects of exchange risk on merchant exporters and importers have been studied by some authors under the assumption of fixed production (Ethier, 1973; Clark, 1973; Hodder, 1977; etc.). Others have investigated the production behaviour of an export firm in a static context (see, for example, Baron, 1976a, b). However, the impact of the greater volatility of exchange rates upon domestic employment and capital accumulation on the one hand and upon international financial transactions on the other has received scant attention in the literature. This paper establishes a dynamic model of a small, competitive firm which is engaged in domestic production, foreign trade (through exports of its products and/or imports of its inputs), and financial transactions in domestic and foreign currencies. Since the firm faces uncertainty about future exchange rates and future prices of outputs and inputs, it attempts to hedge against the risk if it is risk-averse. A forward foreign exchange market is assumed to exist. The firm's decisions on production, investment, forward contracting and financing, which are closely related in the model, are based on exogenously given probability distributions of exchange rates and prices. The paper is planned as follows. Section I presents a model of the firm and formulates its objective function and constraints. Section II solves its maximization problem and interprets the first-order conditions for short-run equilibrium. In particular, three different roles of the firm in the forward exchange or financial market are emphasized: pure hedging, speculative hedging and pure speculation. Section III analyses the dynamic behaviour of a typical open-economy firm. Section IV conducts comparative dynamic exercises of the firm in a long-run steady state equilibrium, and discusses how exchange rate uncertainty affects the firm's optimal decisions. The implications of the purchasing power parity condition are also developed. Section V summarizes our conclusions.