Abstract
This chapter considers the welfare implications of foreign direct investment (FDI) under a flexible exchange rate system, from the viewpoint of a macroeconomic theory. With FDI there can be a conflict between individual firms and the national economy as a whole. Although lower wages may be an incentive for firms to take advantage of FDI, the resulting economic surge may harm the national economy. This comes about first because an increase in unemployment in the home country will reduce that economy’s welfare, and second, an appreciation in the real exchange rate, caused by the remittance of earnings from foreign countries, will reduce the value of profits in terms of domestic goods. This appreciation entirely cancels the benefit from the cost reductions that induce FDI in lower-wage countries, and only the downturn in employment remains. In this sense, a glut in FDI is harmful, and some coordination is required between firms and their government to reduce its effects.
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Notes
- 1.
We assume that the foreign economy does not initially produce the tradable goods. Even after firms of the home economy constructs factories in the foreign economy, the real exchange rate within that economy is kept at unity because any firm faces the same nominal reservation wage.
- 2.
The equilibrium path of the nominal exchange rate, \({{E}_{t}}\), is determined by the fundamental equation s within the home and the foreign economy; that is, by the fundamental equation within the foreign economy, where the prices of tradable and non-tradable goods are equal, \(\alpha {{A}^{-1}}{{[1-{{\eta }^{-1}}]}^{-1}}{{[{{\rho }^{f}}]}^{1-c}}=1\). Here, \({{\rho }^{f}}\) is the inflation rate within the foreign economy. This equation is essentially the same as Eq. (9.18). The fundamental equation of the home economy is Eq. (9.20) Then \({{\left[\frac{{{\rho }^{f}}}{{{\rho }^{h}}}\right]}^{1-c}}\cdot {{e}^{\frac{1}{2}}}=1\). Since the relative prices between the tradable and non-tradable goods are kept constant over time, it is clear that \(\frac{{{\rho }^{f}}}{{{\rho }^{h}}}=\frac{{{E}_{t}}}{{{E}_{t+1}}}\) holds. Thus, the path of the nominal exchange rate is determined as \({{\left[\frac{{{E}_{t}}}{{{E}_{t+1}}}\right]}^{1-c}}\cdot {{e}^{\frac{1}{2}}}=1\).
- 3.
Since the carried-over money of the older generation depends on the income of the previous period, there is an adjustment process towards stationary state. To clarify the discussion, we abbreviate the process.
- 4.
The government of the home economy is assumed to keep the real cash balance constant over time. Then, the budget constraint of the government implies: \({{g}_{t}}=\frac{{{M}_{t}}-{{M}_{t-1}}}{p_{t}^{NT}}=m-\frac{{{M}_{t-1}}}{p_{t}^{NT}}\). Where: \({{g}_{t}}\) is the real government expenditure in terms of the non-tradable goods.
Since the total real cash balance that the older generation carried over is \(\frac{{{M}_{t-1}}}{p_{t}^{NT}}\), the sum of the government and the older generation’s expenditure is: \({{g}_{t}}+\frac{{{M}_{t-1}}}{p_{t}^{NT}}=m\).
- 5.
Equation (9.26) is transformed taking Eq. (9.25) into consideration:
\({{y}^{h}}-c\cdot \left[{{y}^{h}}-\frac{{{E}_{t}}\cdot \widetilde{W_{t}^{R}}}{p_{t}^{NT}}\cdot {{y}^{T}}\right]=m\).
This implies that whenever the foreign exchange market and the aggregated goods market are cleared, the home currency market is also in equilibrium.
- 6.
Note that, as shown in Chap. 2, social welfare is an increasing function of real profits that are proportionate to real GNP.
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Otaki, M. (2015). Industrial Hollowing Under a Flexible Exchange Rate System. In: Keynesian Economics and Price Theory. Advances in Japanese Business and Economics, vol 7. Springer, Tokyo. https://doi.org/10.1007/978-4-431-55345-8_9
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DOI: https://doi.org/10.1007/978-4-431-55345-8_9
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