Exchange Rate Flexibility, Volatility and the Patterns of Domestic and Foreign Direct Investment

IMF Working Papers, March 1, 1992

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Investigates factors determining the impact of exchange rate regimes on the behavior of domestic investment and foreign direct investment (FDI).
Producers may diversify internationally to increase the flexibility of production.
Characterizes possible equilibria in a macro model that allows for the presence of a short-run Phillips curve.
A fixed exchange rate regime is more conducive to FDI relative to a flexible exchange rate; this conclusion applies for both real and nominal shocks.
If the dominant shocks are nominal (real) we will observe a negative (a positive) correlation between exchange rate volatility and the level of investment.

Uses a macro model incorporating a short-run Phillips curve.
Emphasizes producers’ incentives to diversify internationally to increase production flexibility.
Analysis covers both real and nominal shocks and derives implications for investment patterns under different exchange rate regimes.

Fixed exchange rate regimes tend to promote higher FDI relative to flexible regimes.
The sign of the correlation between exchange rate volatility and investment depends on the nature of dominant shocks:
- Dominant nominal shocks → negative correlation between exchange rate volatility and investment.
- Dominant real shocks → positive correlation between exchange rate volatility and investment.