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The author is a Professor of Economics at Dartmouth College and a Research Associate of the National Bureau of Economic Research (NBER). He was a Visiting Scholar in the Research Department when this paper was written. Views expressed are those of the author and not necessarily those of the International Monetary Fund and the NBER.
The data for Figure 1 was taken from the IMF Balance of Payment Statistics. Both FDI flows and trade forms in Figure 1 deal with one side of the balance of payments. Merchandise trade is measured by the value of imports (similar results are obtained if trade is measured by exports). FDI is measured by the flows of FDI into the reporting countries.
For a discussion regarding the factors affecting FDI in recent years and the implications of exchange rate volatility on investment see, for example, Froot and Stein (1989), Edwards (1990), Klein and Rosengren (1990) and Goldberg (1990).
A version of this model was used in Aizenman (1991) to evaluate the implications of restrictions on capital mobility on the welfare ranking of exchange rate regimes.
We construct an intertemporal version of Dixit-Stiglitz (1977) monopolistically competitive framework of the type applied by Helpman-Krugman (1989) in the international context. International transmission of disturbances in the presence of monopolistic competition and nominal rigidities has been dealt with by Dornbusch (1987), Aizenman (1989) and Svensson and van Wijbbergen (1989).
It is noteworthy that our analysis does not imply that a fixed exchange rate is superior to a flexible exchange rate system: one should compare the behavior of employment across regimes, in addition to a comparison of expected consumption. In a different context we have shown that this type of a model implies that the literature of the eighties overstated the case for a flexible exchange rate regime (see Aizenman (1991)).
See Gray (1976) and Fischer (1977). For applications of the Fischer-Gray framework in an open economy see, for example, Flood and Marion (1982), Turnovsky (1983) and Marston and Turnovsky (1985). It is noteworthy that there are alternative ways of modeling the short-run Phillips curve. For example, one can apply Lucas’s framework of incomplete contemporaneous information regarding the decomposition of the aggregate shock into the real and the nominal parts. The key results of our approach can be delivered in such an alternative framework.
The value of 1 - η measures the returns of scale, associated with the presence of fixed costs that may be shared by both locations.
The intermediate case, where producers will be indifferent between the two investment strategies, will occur if all the inequalities in (5) and (6) are replaced with equalities.
Note that the assumption of risk-neutral entrepreneurs implies that investment I in period one, generating nominal income π2 in the second period, will be undertaken if E[π2 /
The simplicity of the example enables us to focus on a closed-form solution, discarding the need to use first-order approximations. While being a special example, is allows us to describe the economics factors at work. Our results can be shown to apply to richer stochastic environments, with any number of states of nature. Our analysis can be readily extended to the case of a positive correlation.
In equation (5),
It can be shown that the elasticity of expected real profits with respect to the number of varieties is [1-α(1+γ)]/α. If the demand for the various varieties is relatively inelastic, more varieties will reduce the labor employed in the productin of a representative variety, raising thereby profits. This will have the consequence that profits will go up with the number of varieties, and that a higher setup cost will imply more producers. The assumption that the varieties are close substitutes rules out this outcome.
We obtain this result in several steps. First, we note that the first period budget constraint is Y1 = Y - mK - .5 nK(1 + η). From (9) and (10) we infer that D2 = IN2 /
Note that (27) represents only the consumption component of the expected utility. To obtain the expected utility, one must subtract from (27) the expected disutility from labor.
Note that the producer cares about the expected real profits. In our monopolistic competitive framework there is positive association between output and real profits, and hence higher expected output implies also higher expected profits.
While the above explanation was given in terms of a multinational producer, the same logic applies for the case of nationalistic producers, where the reallocation of employment should be viewed as reallocation that occurs across states of nature for a given economy.