Bilateral and Third-Country Exchange Rate Effects on Multinational Activity∗

This paper presents a three-country model with coexisting exporters and multinational firms that engage in Cournot competition. In this setting, we study how bilateral and thirdcountry exchange rate shocks pass through into real effects. In particular, the impact of exchange rate movements on the number of foreign subsidiaries and the value of foreign direct investment is at the heart of the paper’s interest. This impact depends on the following trade-off: On the one hand, an appreciation of a foreign currency raises the value of local affiliate sales there (a revenue effect). On the other hand, it reduces costs of foreign market penetration through exports, thereby fosters competition and renders ultinational activities in this country less attractive (a competition effect). The major hypotheses of the theoretical model are then empirically investigated using data on bilateral multinational outbound activities of the US and Japan. To accomplish this task, we employ a generalized method of moments estimation approach that accounts for cross-sectional dependence at the international level.