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Joshua Aizenman is Professor of Economics at Dartmouth College and a Research Associate of the National Bureau of Economic Research.
He holds a Ph.D. from the University of Chicago. The research for this paper was conducted while he was a Visiting Scholar in the Research Department. He would like to thank Guillermo Calvo, John Huizinga, and participants in a seminar given by the Research Department.
World foreign direct investment flows (in the reporting economies) as a fraction of merchandise fob exports between 1965 and 1985 were 0.029. From 1985 this ratio has increased remarkably, and between 1986 and 1990 it reached 0.054 (see International Monetary Fund (various years)).
For a discussion regarding the factors affecting direct foreign investment in recent years and the implications of exchange rate volatility for investment, see Froot and Stein (1989), Edwards (1990), Klein and Rosengren (1990), and Goldberg (1990). For a discussion regarding the optimal currency area, see Mundell (1961), McKinnon (1963), Corden (1991), and Boughton (1991).
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.
This construct is an intertemporal version of Dixit and Stiglitz’s (1977) monop-olistically competitive framework of the type applied by Helpman and 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 Wijnbergen (1989).
This analysis does not imply that a fixed exchange rate regime is superior to a flexible exchange rate system; for such a judgment, one would need to compare the behavior of employment across regimes, in addition to expected consumption. In a different context Aizenman (1991) has shown that this type of model implies that the literature of the 1980s overstated the case for a flexible exchange rate regime.
This employment target equals the expected employment level that will prevail in the absence of nominal contracts, and is determined by preferences and technology. The employment target is equivalent to the concept of the expected full-employment level. For the purposes here, is taken as given, assuming that it is not affected by the nature of the exchange rate regime. There are alternative ways of modeling the short-run Phillips curve that would produce similar results. An example is Lucas’s framework of incomplete contemporaneous information regarding the decomposition of the aggregate shock into the real and the nominal parts.
Starting with employment level in both countries, a marginal reduction of employment in the less productive country and a corresponding increase in the more productive country will increase the multinational’s expected profits by the divergences of the marginal product of labor at points B and A.
The value of 1 - η measures the returns to scale associated with the presence of fixed costs that may be shared by both locations. Entrepreneurs may also increase their production capacity by investing in two plants at home, at a capita) cost of K(1 + η) In the absence of transportation costs and uncertainty, producers will be indifferent between choosing to produce in two plants operating at home, or one operating at home and one abroad. A small uncertainty (as well as small transportation costs) will suffice, however, to brake this indifference: producers who operate with two plants prefer to diversify internationally, benefiting from both the extra capacity and the diversification of country-specific shocks (Section III discusses these points in further detail).
Note that the assumption of risk-neutral entrepreneurs implies that investment I in period 1, generating nominal income, II2, in the second period, will be undertaken if E[II2/2] –I(1+ρ)⩾ 0 It can be shown that if the supply of Y is small enough, the Cobb-Douglas production function (defined by equation (3)) implies a corner solution where all Y is invested, and none is consumed in the first period. In such a case, the real interest rate is determined by the marginal productivity of capital. If the supply of Y is large enough to ensure positive consumption in period 1, the real interest rate is determined by preferences (that is, it is equal to 1 + ρ). In such a case, the actual investment is determined by the demand for investment at that real interest rate.
The simplicity of the example enables one to focus on a closed-form solution, dispensing with the need to use first-order approximations. Although it is a special example, it allows one to describe the economic forces at work. The results can be shown to apply to richer stochastic environments with any number of states of nature, and the analysis can be readily extended to the case of a positive correlation.
It can be shown that the elasticity of expected real profits with respect to the number of varieties is [1 - a(l + γ)] /α. If the demand for the various varieties is relatively inelastic, more varieties will reduce the labor employed in the production of a representative variety, thereby raising profits. This implies that profits will go up with the number of varieties, and that a higher set-up cost will imply more producers. The assumption that the varieties are close substitutes rules out this outcome.
In equation (5), E[πnd]=E[(1-σγ)P2, iDs2, i/2 The value of E[πd is obtained by calculating the profits that will occur to a marginal producer that will switch to a multinational strategy (assuming that all other producers behave as nondiversified).
This result follows from the fact that (1+h)x/[(1+h)x + (1+h)x] increases with x. The corresponding values of x for the nondiversified and the diversified regimes are α/(1-αγ), and 1/(1 - γ). respectively.
Recall that there is no labor mobility. Hence, no labor crosses borders, and employment reallocation is achieved by changing the employment level in each country.
As was discussed above, in the diversified regime there is no adjustment of real wages, and, hence, the reallocation of employment is more pronounced.
This result follows from the fact that the flexibility of the exchange rate stabilizes employment in the presence of productivity shocks under both the nondiversified and the diversified regime. The stabilization of employment implies also the stabilization of the aggregate output of a multinational, because the shocks affecting the two countries are negatively correlated. Recall that complete employment stabilization is due to the unitary elasticity of the demand for money with respect to output. It can be shown that the stabilization of employment achieved by the flexibility of the exchange rate (relative to employment under a fixed exchange rate regime) holds for a general demand for money.
Following the logic of the previous discussion regarding Figure 2, the expected output difference between the fixed and flexible exchange rate regime, in the absence of diversification, is equal to half the dotted area in Figure 2.
Curve FL in panel A of Figure 3 is drawn by plotting equations (18a) and (18b) as a function of the volatility, h, recognizing that the switch from a nondiversifled to a diversified regime is determined by equation (19).
Although a higher volatility does not affect the expected output (because of the stabilization of employment), it will depress expected real profits because of the induced relative price adjustment. Note that the analysis here suggests that the correlation between the volatility of shocks and investment depends on the nature of shocks and the nature of the exchange rate regime. For example, whereas higher volatility of productivity shocks will increase investment under a fixed exchange rate regime, it will tend to depress investment under a flexible exchange rate.
FL is a plot of equations (23a) and (24a) as a function of the volatility, h; the switch from a nondiversified to a diversified regime is determined by equation (25). The international diversification achieved with multinationals shifts the supply of each variety from nationalistic to multinational sources, thereby stabilizing the aggregate output of each variety. Note that the labor market remains nationalistic, since monetary policy continues to affect real wages and employment. It can be shown that for large volatility the diversification partially lessens the impact of monetary shocks (that is, for a large enough h, FL,N in panel B of Figure 3 is below FL,D).
The realiocation of employment between countries is achieved by adjusting the employment level in each country.
Note that the producer cares about expected real profits. In the monopolistic competitive framework used here, output and real profits are positively associated, and, hence, higher expected output also implies higher expected profits.
See Frankel and Froot (1990) for an analysis of bubbles as a potential driving force in the evolution of exchange rates.
In these circumstances, the higher volatility of monetary shocks under a flexible exchange rate may increase foreign direct investment and depress aggregate investment. Recall that the model predicted that volatile monetary shocks under a flexible exchange rate will lead to diversification. It can be verified that with volatile monetary shocks, welfare tends to be lower if producers are not allowed to operate as multinationals. In terms of Figure 3, for a large enough h, the curves associated with the nondiversified regime are below the curves associated with the diversified one. Thus, capital mobility works to lessen the adverse consequences of monetary shocks (for further details, see Aizenman (1991)).
Applying equations (34), (44), and (45) from the appendix, it follows that in the non diversified regime the elasticity of the real exchange rate with respect to productivity shocks is larger under a fixed exchange rate. Expressed formally, dlog[Pr/SP*]/d log(a/a*) equals 1 - α under a flexible exchange rate regime, and (1 - α)/(l - αγ) under a fixed exchange rate. The reason is that the real exchange rate should clear the goods market. Hence, greater disparity of the supply adjustment across regimes will necessitate greater relative price adjustment. Exchange rate flexibility works to stabilize employment and to reduce the supply disparity across regimes, and, hence, it will require a smaller adjustment of the relative prices.