Vertical FDI and exchange rates over the business cycle: The welfare implications of openness to FDI

Abstract

It has long been observed that a country tends to receive increased net foreign direct investment (FDI) inflow when its currency depreciates. We build an open-economy macroeconomic model that accounts for the positive correlation, and re-examine the welfare implications of FDI, focusing mainly on the short run. We show that short-run FDI fluctuations exacerbate utility loss over business cycles in an environment with monetary shocks, but have little impact on welfare over business cycles caused by productivity shocks. The best outcome occurs when the economy retains long-run FDI, but restricts short-run movements in the production location of firms.