FDI and Exchange Rates: A Theoretical Investigation about the Role of MNCs

Although FDI is considered to be more stable form of investment than portfolio investment (Lipsey, 1999), certain variables that actually determine the volume of short-term capital flows and portfolio financing, can also affect the composition and the direction of real capital flows. The importance of taking into consideration more explanatory variables, such as the exchange rate regime, is emerging in many recent studies on FDI, since in some cases exchange rates may affect the composition of physical capital investments more than they would affect financial investment decisions. We introduce the role of MNCs and consider whether exchange rate would affect their decisions in expanding abroad. In particular, we construct a model that considers the locational choice of a horizontal MNC, assuming that the investment decision in based on the relationship between FDI and exchange rates. Our results are in line with the findings of the relative literature so far and demonstrate that an appreciation of the home country currency or a depreciation of the host country currency enhance FDI in the host country. Moreover, FDI in the host country is attracted by potential increases in labour productivity in both countries as well as by the reduction of labour costs in the host economy.