The effect of exchange rate on foreign direct investment

It is generally accepted that a depreciation in the currency of one country increases foreign direct investment flows into that country. However, studies based on an option pricing approach and recent FDI flows data from Japan into the US suggest that the FDI flows may decrease as the currency of the host country depreciates. We model firms which may choose between domestic production (and exporting) and production in the foreign country. The study examines the effect of exchange rate on the mode of operation of the firms. We find that a depreciation in the currency of the host country will unambiguously raises FDI flows from foreign firms only if initially the firms are mainly exporting. Once they have become multinationals, the depreciation in the currency of the host country may give different effect on the FDI flows. If the foreign firms have technological advantage, the currency depreciation reduces FDI flows from the foreign country; however, when the foreign firms have technological disadvantage, they will increase their FDI