Exchange rates and foreign direct investment

Exchange rates and foreign direct investment: Exchange Rate Levels

Exchange rates and foreign direct investment: Exchange Rate Volatility

One of the many influences on foreign direct investment (FDI) activity is the behavior of exchange rates. Exchange rates, the domestic currency prices of foreign currencies,matter in terms of both their levels and their volatility. Exchange rates can influence the total amount of FDI that takes place and the allocation of this investment spending across a range of countries.

Understanding the effects of exchange rates on FDI is important for many reasons. For example, alternative exchange rate arrangements adopted by countries can reduce nominal changes in the relative values of currencies, sometimes even merging the currencies completely through a monetary union. For countries trying to attract more FDI, what roles do exchange rate levels and volatility play in determining the attractiveness of these countries for FDI? Can countries make themselves more or less attractive bymanipulating the exchange rate?

See also exchange rate regimes; exchange rate volatility; location theory

FURTHER READING

• Aizenman, Joshua. 1992. ‘‘Exchange Rate Flexibility, Vol atility, and Patterns of Domestic and Foreign Direct Investment.’’ International Monetary Fund Staff Papers 39 (4): 890 922. Investigates the factors determining the impact of exchange rate regimes on the behavior of domestic investment and FDI, and the correlation be tween exchange rate volatility and investment. 
• Blonigen, Bruce A. 1997. ‘‘Firm Specific Assets and the Link between Exchange Rates and Foreign Direct In vestment.’’ American Economic Review 87 (3): 447 965. Uses data on Japanese acquisitions of U.S. industries to show that dollar depreciation raises the likelihood of such acquisitions, especially in industries with high firm specific assets. 
• Cushman, David O. 1985. ‘‘Real Exchange Rate Risk, Ex pectations, and the Level of Direct Investment.’’ Review of Economics and Statistics 67 (2): 297 308. Shows U.S. annual bilateral direct investment to industrialized countries responds significantly to expected dollar de preciation and risk. 
• . 1988. ‘‘Exchange Rate Uncertainty and Foreign Direct Investment in the United States.’’ Welt wirtschaftliches Archiv 124 (2): 322 34. Attempts to clarify the ways that exchange rate uncertainty can affect FDI and tests for these effects on U.S. FDI inflows. 
• Froot, Kenneth A., and Jeremy C. Stein. 1991. ‘‘Exchange Rates and Foreign Direct Investment: An Imperfect Capital Markets Approach.’’ Quarterly Journal of Eco nomics 106 (4): 1191 1217. Model showing that when global capitalmarkets have informational imperfections, depreciation lowers the relative wealth of domestic agents and leads to foreign acquisitions. 
• Goldberg, Linda S. 1993. ‘‘Exchange Rates and Investment in United States Industry.’’ Review of Economics and Statistics 75 (4): 575 88. Shows how exchange rate level and volatility effects on real investment spending differ over time and across U.S. industries. 
• Goldberg, Linda S., andCharlesD.Kolstad. 1995. ‘‘Foreign Direct Investment, Exchange Rate Variability, and De mand Uncertainty.’’ International Economic Review 36 (4): 855 73. Model and empirical results show that shares of production capacity located abroad rise as ex change rate volatility rises and becomes more correlated with export demand shocks. 
• Klein, Michael W., and Eric S. Rosengren. 1994. ‘‘The Real Exchange Rate and Foreign Direct Investment in the United States: Relative Wealth vs. Relative Wage Ef fects.’’ Journal of International Economics 36 (3 4): 373 89. Tests the Froot and Stein 1991 model, showing relative wealth effects stronger than relative wage effects of exchange rates on U.S. inward FDI. 

LINDA S. GOLDBERG