Department of Economics, UCSC

This paper argues that when the exchange rate and projected sales in the host country are jointly determined by underlying macroeconomic variables, standard regressions of FDI flows on both exchange rate levels and volatility are subject to bias. The results hinge on the interaction of macroeconomic uncertainty, a sunk cost, and heterogeneous productivity across firms. They indicate that a multinational firm’s response to increases in exchange rate volatility will differ depending on whether the volatility arises from shocks in the firm’s native or host country. It is the first study to depart from the representative-firm framework in an analysis of direct investment behavior with money.