This Paper is Concerned With the role of foreign direct investment (FDI) in the external adjustment process. In particular, it investigates the extent to which flows of FDI are affected by changes in countries’ relative competitiveness and real levels of aggregate demand. To this end, a simple model is developed to explain how a multinational firm locates its production facilities among different countries. This location model is then incorporated into a neoclassical investment function to explain the world-wide plant and equipment expenditures by multinational firms. The factors influencing the distribution of financing for these expenditures are then discussed, and a model of direct investment flows is derived. The results indicate that, in general, FDI flows are strongly influenced by changes in both real levels of demand and by countries’ relative competitiveness.
The plan of the paper is as follows: Section I begins with a brief review of the size of FDI flows and their relative importance for different countries. Section II discusses the possible effects of real exchange rate changes on the profitability of production in different countries and develops the model of plant and equipment expenditures by the multinational firm. Section III discusses the influences on the financing of these expenditures, and Section IV derives the final estimating equation for FDI and discusses its empirical application. Section V presents the results from fitting this equation for the FDI inflows and outflows of the United States, the United Kingdom, Japan, and the Federal Republic of Germany. Section VI contains a brief summary of the major results and conclusions.
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Mr. Goldsbrough, economist in the External Adjustment Division of the Research Department when this paper was prepared, is currently economist in the African Department. He is a graduate of Cambridge University and received his master’s degree and doctorate from Harvard University.
Note that the portion of the subsidiary’s reinvested earnings that belongs to the parent company is treated as financing from outside the host country and is included in the definition of FDI flow for each of the four countries considered in the empirical analysis.
An attempt was made to construct this variable using a weighted average of host country movements in the GDP output deflator relative to the capital goods deflator. (If the capital goods deflator was not available, some suitable wholesale price index for capital goods was used.) However, the simpler model treating this term as a constant gave a better fit, and the estimated parameters were not significantly altered. This has also been the experience with most applications of the neoclassical model to domestic investment expenditures.
If investment decisions were truly taken according to the “myopic” model, the firm would have no reason to borrow for more than one period at a time, and a short-term rate would be appropriate. However, since capital goods cannot easily be resold once they are installed, the myopic model is not strictly applicable, and most capital expenditures are, in fact, financed by long-term borrowing.
Austria, Belgium, Canada, France, the Federal Republic of Germany, Italy, Japan, the Netherlands, Sweden, Switzerland, the United Kingdom, and the United States.
The 12 countries used in the various weighting schemes are Austria, Belgium, Canada, France, the Federal Republic of Germany, Italy, Japan, the Netherlands, Sweden, Switzerland, the United Kingdom, and the United States.