Vertical FDI and Exchange Rate in a Two Country Model with Heterogeneous Firms

To many developing countries nowadays, Foreign direct investment (FDI) is regarded as an important factor that promotes growth. While traditional theory states that FDI helps increasing labor income by bringing capital to laborabundant countries, more recent works points to the possibility that type of capital in‡ow matters as well. Various studies of …nancial crisis highlight the stability of FDI compared with portfolio in‡ows.1 Probably most importantly, FDI in‡ows are believed to have positive externality of technology spillover. Host country …rms can learn to be more productive and e¢ cient by learning from the foreign …rms. Theories explaining the determinants of FDI are abundant. Compared with traditional theories focusing on competitive advantages, such as better technology or managerial skill, studies examining the link between exchange rate and FDI are relatively new. Conventional wisdom suggests that a depreciation of domestic currency attracts FDI because it makes domestic factors of production cheaper, but earlier economists typically reject the idea as when making an investment decision, what matters is the rate of return of the underlying asset. If, for example, a depreciation of the dollar makes an US asset cheaper to a potential foreign investor, one should also realize that the future bene…ts to be generated by the asset are also a¤ected by the depreciation. In particular, if we believe that movements in exchange rate resemble a random walk, then in expectation, the value of future bene…ts of the asset must reduce by the same proportion as the cost of the asset. Therefore, as the depreciation leaves the rate of return unchanged, there is no reason that a depreciation should enhance foreigner’s incentive to purchase US asset. Despite the theoretical challenge, empirical works that started to emerge during the 1980s have consistently found a positive relationship between the exchange rate, de…ned as domestic currency price of foreign currency, and FDI