The Effect of Exchange-rate Uncertainty on Foreign Direct Investment in the United Kingdom

Abstract

According to the theory of purchasing power parity (PPP), exchange-rate movements offset the effect of relative price changes on the terms of trade, thus serving as a stabilizing influence on an economy’s external position, protecting real variables from local shocks. In practice, however, exchange rates have deviated substantially and for lengthy periods from the rates implied by PPP, and in this case, exchange-rate movements, rather than serving to absorb real shocks (as in PPP), are a potential cause of shocks.1,2 An additional but separate issue of concern relates to the volatility of nominal and real exchange rates, a marked feature of recent experience of flexible exchange-rate regimes. Various studies have emerged exploring the impact of exchange-rate volatility (and associated uncertainty) on investment and growth (discussed further below). In this chapter we extend the literature, using an original database to explore the relationship between foreign direct investment and exchange-rate variability, with respect to both the level and volatility of exchange rates, for the case of the United Kingdom between 1997 and 2001.