EXCHANGE RATES, INFLATION, AND INTERNATIONAL DIRECT INVESTMENT

This analysis develops a segment of an overall financial planning model for a U.S.-based multinational corporation which services the foreign market by establishing a wholly-owned subsidiary in the host country. The primary objective of the thesis is to establish the effect of changes in steady-state host country inflation and the steady-state exchange rate on the growth of investment by the parent in the subsidiary. The foreign direct investment is viewed as an income-generating asset which is part of the corporation's investment portfolio. Hence, the rationale behind including this type investment in the portfolio is examined. Attributable to the fact that the corporation operates in a dynamic environment, the specific framework consists of a steady-state growth model. Starting with a Cobb-Douglas production function and a market structure which exhibits less than perfect competition, the marginal revenue product of capital is derived. Under three general financing methods, alternative discount rates are derived and used to capitalize the marginal revenue product of capital. Such capitalization yields the desired level of physical capital stock under each alternative method of financing. Time derivatives of these resultant expressions are taken to obtain the desired level of investment. Comparative dynamics are used for sensitivity analysis. The results indicate that the sensitivity of investment by the parent to changes in steady-state host country inflation and the steady-state exchange rate depends upon the responsiveness of the after-tax real rate of interest to changes in these factors. The existence of the corporate tax structure may prevent the nominal rate of interest from changing sufficiently to offset any change attributable to steady-state host country inflation and the steady-state exchange rate. Hence, the parent must respond accordingly.