Foreign direct investment and inflation
Southern Economic Journal
Wiley-Blackwell Publishing, Inc.
419 - 443
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Multinational enterprises (MNEs) are able to shift investments between home and host countries to minimize the negative effects of changes in the macroeconomic environment. This article formalizes a model that allows studying this investment-smoothing behavior of MNEs facing inflation taxes in both the home and the host country. The MNE is allowed to invest in two economies, home and host, and to finance its foreign direct investment (FDI) either through domestic or foreign sources. The investment smoothing by the MNE is studied for cases of both vertical and horizontal FDI. The results suggest FDI is used as a hedging tool, mitigating the effects of inflation taxes even if there are no formal hedging mechanisms. The investment-smoothing reaction of MNEs depends on the reason for investment, the financing sources of FDI, and the substitutability between factors of production. Finally, this investmentsmoothing possibility (FDI) reduces the real negative effects of inflation.