Endogenous Flows of Foreign Direct Investment and International Real Business Cycles

No 2011-E16, GSIA Working Papers from Carnegie Mellon University, Tepper School of Business

Abstract: This paper models flows of foreign direct investment (FDI) in a two country, two sector DSGE framework. The allocation of capital to production capacity abroad is subject to a search-and-matching friction with endogenous capital reallocation. The model is calibrated on observed inflows and outflows of FDI and leads to dynamics of foreign direct investment consistent with the empirical evidence documented in this paper: relative to domestic investment, FDI is more volatile, and inward and outward flows of FDI are positively correlated. This contrasts with a standard International Real Business Cycle model which predicts a negative correlation and low volatility. More- over, the model generates cross-country aggregate investment correlations consistent with the data.

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