This paper analyzes the implications of exchange rate flexibility for the patterns of domestic and foreign direct investment. It considers a model for two countries, two periods, and two classes of goods. The economy is subject to productivity and monetary shocks, and the supply side is characterized by the presence of a short-run Phillips curve. In the first period, entrepreneurs face investment decisions. The paper assumes that labor is immobile and that installed capital is location-and sector-specific. There is a lag between the implementation of investment in productive capital and the availability of the productive capacity. Foreign direct investment is motivated by the multinational producer’s attempt to increase the flexibility of production: a producer can reallocate employment and production toward the more efficient or the cheaper plant. This flexibility gives the producer the option of adjusting its international production pattern to the realization of shocks, at the cost of creating the extra productive capacity. The investment is implemented by risk-free entrepreneurs. The model assumes free entry; thus, equilibrium requires that the expected economic rent be dissipated.
The key outcome of the analysis is that a fixed exchange rate regime is more conducive to foreign direct investment than a flexible exchange rate; this conclusion applies for both real and nominal shocks. It is shown that, for a given characterization of shocks, the resultant foreign direct investment is higher in a fixed exchange rate regime. In the case of monetary shocks, the concavity of the production function implies that volatile nominal shocks will reduce expected profits under a flexible exchange rate regime. Fixed exchange rates are better at isolating real wages and production from monetary shocks and are thus associated with lower volatility and higher expected profits. The higher expected income is, in turn, supporting higher foreign direct investment. For real shocks, flexible exchange rates are associated with lower volatility of employment and lower expected profits. This conclusion stems from the observation that a country experiencing a positive productivity shock will tend to experience nominal and real appreciation, which will mitigate (and may even eliminate) the resultant employment expansion. In a fixed exchange rate system, the nominal appreciation mechanism does not work; hence, employment will have a greater tendency to expand in the presence of a positive productivity shock than under a flexible rate. The greater reallocation of employment toward the more efficient country in a fixed exchange rate regime will tend to increase expected profits, thereby encouraging investment. The paper also demonstrates that under a flexible exchange rate regime, more volatile real shocks will increase investment and international trade, whereas a higher volatility of nominal shocks will reduce investment and trade.