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 foreign direct investment (FDI) inflow when its currency depreciates. We provide an explanation of this correlation and examine the implied welfare effects of short-run FDI flow. Firms' cross-border production location decisions are analyzed in an open-economy macroeconomic model in which both the exchange rate and FDI flow are endogenously determined. The exchange rate and FDI flow are positively correlated under monetary or productivity shocks. Furthermore, we show that short-run FDI fluctuations exacerbate utility loss over business cycles in an environment with nominal shocks, but has little impact on welfare over business cycles caused by productivity shocks. The first best outcome occurs when the economy retains long-run FDI, but restricts short-run movements in the production location of firms.