Recent discussions of exchange rate determination have increasingly emphasized the possible role of foreign direct investment (FDI) in influencing exchange rate behavior. Yet, there are few existing models of multinational enterprises (MNEs) and endogenous exchange rates. This paper demonstrates that the entry decisions of MNEs influence the volatility of the real exchange rate in countries were there are significant costs involved in maintaining production facilities, even when prices are perfectly flexible. For plausible parameterizations, MNE activity can make the exchange rate more volatile than relative consumption.
In this paper we draw on three different strands of international macroeconomics and trade: (i) the role of returns on foreign direct investment and other assets in determining the exchange rate; (ii) recent work on the behavior of heterogeneous exporters and MNEs; and (iii) studies of the exchange-rate disconnect puzzle. In what follows, we discuss these approaches in turn to highlight how they motivate and inform our approach.
It is well known that the volatility of the exchange rate is much higher than that of other macroeconomic variables, such as the aggregate price level and consumption. This produces a fundamental challenge for optimization-based open economy models that link marginal rates of substitution to international goods prices. For instance, Baxter and Stockman (1989) and Flood and Rose (1995) point out that nominal and real exchange rate volatility is typically ten times higher than the volatility of relative prices and several times times greater than the volatility of output or consumption.
As demonstrated by Backus, Kehoe, and Kydland (1992), standard open economy business cycle models have difficulty replicating these stylized facts unless implausible substitution elasticities are assumed. This is due to the tight link between marginal rates of substitution and international relative prices that are at the heart of optimization-based frameworks.
Download
Entry, Multinational Firms and Exchange Rate Volatility
