This article investigates the relationship between exchange rate variability and direct investment. We distinguish between two kinds of exchange rate variations: short-term volatility and longer-term misalignment. Theoretical considerations indicate that the influences of both kinds of exchange rate variations on direct investment are ambiguous. We then review the empirical literature on this issue, which supports the theoretical findings. We conclude that, contrary to the arguments of proponents of managed exchange rate regimes, the increased variability of exchange rates under the managed floating system has not been harmful to direct investment.
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References
1.
1. See, for example, Rudiger Dornbusch and Jeffrey Frankel, “The Flexible Exchange Rate System: Experience and Alternatives,” in International Trade and Finance in a Polycentric World, ed. S. Borner (London: Macmillan, 1988), pp. 151-197.
2.
2. See, for example, Harry G. Johnson, “The Case for Flexible Exchange Rates, 1969,”Review (Federal Reserve Bank of St. Louis), 51:12-24 (June 1969).
3.
3. Ibid., pp. 19-20.
4.
4. Jacob Frenkel and Morris Goldstein, “Exchange Rate Volatility and Misalignment: Evaluating Some Prospects for Reform,” in Financial Market Volatility (Kansas City: Federal Reserve Bank of Kansas City, 1989).
5.
5. Martin J. Bailey and George S. Tavlas, “Trade and Investment under Floating Exchange Rates: The U.S. Experience,”CATO Journal, 8:421-442 (Fall 1988).
6.
6. See ibid. for a discussion of the relationship between exchange rate variability and trade performance.
7.
7. John Williamson, The Exchange Rate System (Washington, DC: Institute for International Economics, 1985).
8.
International Monetary Fund , Exchange Rate Volatility and World Trade, Occasional Paper no. 28 (Washington, DC: International Monetary Fund, 1984).
9.
9. Williamson, Exchange Rate System.
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10. Paul Krugman, Exchange Rate Instability (Cambridge, MIT Press, 1989).
11.
11. Bailey and Tavlas, “Trade and Investment.”
12.
12. For a discussion of the choices of firms of currency for international transactions in response to risks, see George S. Tavlas, On the International Use of Currencies: The Case of the Deutsche Mark, Essays in International Finance (Princeton, NJ: Princeton University, Jan. 1991).
13.
13. Martin J. Bailey, George S. Tavlas, and Michael Ulan, “The Impact of Exchange Rate Volatility on Export Growth: Some Theoretical Considerations and Empirical Results,”Journal of Policy Modeling, 9:225-243 (Spring 1987).
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14. Richard Baldwin and Paul Krugman, “Persistent Trade Effects of Large Exchange Rate Shocks,”Quarterly Journal of Economics, 104:635-654 (Nov. 1989).
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15. Bailey and Tavlas, “Trade and Investment.”
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16. Avinash Dixit, “Review of Exchange Rate Instability,”Journal of Economic Literature, 28:705-707 (June 1990).
17.
17. The effects of autonomous shifts of trade and investment flows on exchange rates would occur simultaneously with the observed changes, except to the extent that traders do not learn instantly of the fundamentals involved in such autonomous shifts but learn with a big enough lag that the relationships between these variables depend on previous values of other variables.
18.
18. Bailey and Tavlas, “Trade and Investment.”
19.
19. Peter B. Kenen, “Exchange Rate Variability: Measurement and Implications,” mimeographed (Princeton, NJ: Princeton University, June 1979).
20.
20. International Monetary Fund, Exchange Rate Volatility and World Trade.
21.
21. Ibid., p. 28.
22.
22. David O. Cushman, “Real Exchange Rate Risk, Expectations, and the Level of Direct Investment,”Review of Economics and Statistics, 67:297-308 (May 1985).
23.
23. David O. Cushman, “Exchange Rate Uncertainty and Foreign Direct Investment in the United States,”Weltwirtschaftliches Archiv, Band 124, pp. 322-336 (Heft 2, 1988).
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24. Bailey and Tavlas, “Trade and Investment.”
25.
25. Anation's gross domestic product is the total product produced or income earned in that country. Gross national product is the total income earned by residents of the country—from domestic or foreign sources.
26.
26. Quoted in Foreign and Exchange Markets in October 1990 (Washington, DC: International Monetary Fund, 1990), p. 4.
