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Economic Quarterly

First Quarter 2012

Exchange Rate Volatility in a Simple Model of Firm Entry and FDI

Thomas A. Lubik and Katheryn N. Russ

Recent discussions of exchange rate determination have emphasized the possible role of foreign direct investment in influencing exchange rate behavior. Yet, there are few existing models of multinational enterprises (MNEs) and endogenous exchange rates. This article demonstrates that the entry decisions of MNEs can influence the volatility of the real exchange rate in countries where there are significant costs involved in maintaining production facilities, even when prices are perfectly flexible. We develop an analytically tractable framework with closed-form solution, but show that the existence of any amplification effect through the entry mechanism rests on a narrow set of parameter values.

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