International Investment Theories

Ownership Advantages Internalization Dunnings Eclectic Theory

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Ownership Advantages

A firm owning a valuable asset that creates a competitive advantage domestically can use that advantage to penetrate foreign markets through FDI.

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Internalization Theory

FDI is more likely to occur when transaction costs with a contracting firm are high. Transaction costs: costs associated with negotiating, monitoring, and enforcing a contract
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Dunnings Eclectic Theory

FDI reflects both international business activity and business activity internal to the firm, and three conditions for FDI are:

ownership advantage location advantage advantage

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Factors Affecting the FDI Decision

Supply Factors Production costs Logistics Demand Factors Customer access Marketing advantages Political Factors Avoidance of trade barriers Economic development incentives

Resource availability Exploitation of competitive advantages Access to technologyCustomer mobility

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OpenEconomy

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Open and Closed Economies

u A closed economy is one that does

not interact with other economies in the world.

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There are no exports, no imports, and no capital flows.

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Open and Closed Economies

An open economy is one that interacts freely with Click to edit Master subtitle style other economies around the world.

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An Open Economy
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other countries in two ways.

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It buys and sells goods and services in world product markets. It buys and sells capital assets in world financial markets.

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An Open Economy

u India is an open economy u The U.S. is a very large and open

economy it imports and exports huge quantities of goods and services.

u Over the past four decades,

international trade and finance 4/30/12 have become increasingly

The Flow of Goods: Exports, Imports, Net Exports

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Exports are domestically produced goods and services that are sold abroad. Imports are foreign produced goods and services that are sold domestically.

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The Flow of Goods: Net Exports & Trade Balance

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Net exports (NX) are the value of a nations exports minus the value of its imports. Net exports are also called the trade balance.

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The Flow of Goods: Trade Deficit, Trade Surplus Balanced Trade

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A trade deficit is a situation in which net exports (NX) are negative. Imports > Exports A trade surplus is a situation in which net exports (NX) are positive. Exports > Imports Balanced trade refers to when net exports are zero exports and imports 4/30/12 are exactly equal.

Factors That Affect Net Exports

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The tastes and preferences of consumers for domestic and foreign goods The prices of goods at home and abroad The exchange rates at which people can use domestic currency to buy foreign currencies

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Factors That Affect Net Exports

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The incomes of consumers at home and abroad. The costs of transporting goods from country to country. The policies of the government toward international trade.

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Imports and Exports of the US Economy

Perce nt of GDP 1

Impor ts 1 0

Expor ts

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196

196

1970

1975

1980 1985 1990 19

19

The Flow of Capital Net Foreign Investment

u Net foreign investment/ Net capital

outflow refers to the purchase of foreign assets by domestic residents minus the purchase of domestic assets by foreigners.
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A US resident buys stock in the Toyota corporation and a Mexican buys stock in the Ford Motor corporation

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The Flow of Capital: Net Foreign Investment

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When a U.S. resident buys stock in Telmex, the Mexican phone company, the purchase raises U.S. net foreign investment. When a Japanese residents buys a bond issued by the U.S. government, the purchase reduces the U.S. net foreign investment.

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Variables that Influence Net Foreign Investment

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The real interest rates being paid on foreign assets The real interest rates being paid on domestic assets The perceived economic and political risks of holding assets abroad

The government policies that affect 4/30/12 foreign ownership of domestic

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The Equality of Net Exports and Net Foreign Investment

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Net exports (NX) and net foreign investment (NFI) are closely linked. For an economy as a whole, NX and NFI must balance each other so that:

NFI = NX
This holds true because every transaction that affects one side must 4/30/12 also affect the other side by the same
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Saving, Investment, and the International Flows

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Net exports is a component of GDP:

Y = C + I + G + NX
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National saving is the income of the nation that is left after paying for current consumption and government purchases:

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S = Y - C - G = I + NX

Saving, Investment, and Their Relationship to the International Flows

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National saving (S) equals Y-C-G so:

S = I + NX Saving =
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or Domestic + Foreign Investment Investment

National Saving, Domestic Investment, and Net Foreign Investment

(a) National Saving and Domestic Investment (as a percentage of GDP) Perce of nt GDP 2 0 1 8 1 6 1 4 1 2 1 4/30/12 19 0 65

Domestic investment

National saving

19 70

19 75

19 80

19 85

19 90

19 95

20 00

National Saving, Domestic Investment, and Net Foreign Investment

Perce of nt GDP 4 3 2 1 0 1 (b) Net Foreign Investment (as a percentage of GDP)

Net investme foreign nt

2 3 4 19 4/30/12 65

197 0

197 5

198 0

198 5

199 0

199 5

20 00

Real and Nominal Exchange Rates

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International transactions are influenced by international prices. The two most important international prices are the nominal exchange rate and the real exchange rate.

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Nominal Exchange Rates

The nominal exchange rate is the rate at which a person can trade the currency of one country for the currency of another.

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Nominal Exchange Rates

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The nominal exchange rate is expressed in two ways:

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In units of foreign currency per one U.S. dollar. And in units of U.S. dollars per one unit of the foreign currency.

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Nominal Exchange Rates

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Assume the exchange rate between the Japanese yen and U.S. dollar is 80 yen to one dollar.
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One U.S. dollar trades for 113 yen. One yen trades for 1/113 (=0.00885) of a dollar.

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Nominal Exchange Rates

If a dollar buys more foreign currency, there is an appreciation of the dollar. If it buys less there is a depreciation of the dollar.

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Real Exchange Rates

The real exchange rate is the rate at which a person can Click to edit Master subtitle style trade the goods and services of one country for the goods and services of another.

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Real Exchange Rates

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The real exchange rate compares the prices of domestic goods and foreign goods in the domestic economy.
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If a case of German beer is twice as expensive as American beer, the real exchange rate is 1/2 case of German beer per case of American beer.

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Real Exchange Rates

The real exchange rate depends on the nominal exchange rate and the prices Click to edit Master subtitle style of goods in the two countries measured in local currencies.

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Real Exchange Rates

Real Exchange Rate

The real exchange rate is a key determinant of how much a country exports and imports.

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Real Exchange Rates

The real exchange rate is the rate at which a person can trade the goods and services of one country for the goods and services of another. Trading depends on the physical quantities that can be exchanged at given exchange rates AND the prices of the good in each country Example, a Honda in Japan costs 4,000,000 yen and $20,000 in the US. Assuming an exchange rate of 100 yen/dollar, the Honda costs Y2,000,000 in 4/30/12 the US. Thus, Hondas are as expensive

Real Exchange Rates

Real Exchange Rate = Exchange Rate x PUS PJap

For Example above EP/P*= 100 yen/dollar x $20,000

Y4,000,000 = HondaJAPAN/1 HondaUS

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So, the real exchange rate is a key

Real Exchange Rates

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A depreciation (fall) in the U.S. real exchange rate means that U.S. goods have become cheaper relative to foreign goods. This encourages consumers both at home and abroad to buy more U.S. goods and fewer goods from other countries.

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Real Exchange Rates

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As a result, US exports rise, and US imports fall, and both of these changes raise U.S. net exports. Conversely, an appreciation in the US real exchange rate means that US goods have become more expensive compared to foreign goods, so U.S. net exports fall.

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PURCHASING-POWER PARITY

A theory of exchange-rate determination The purchasing-power parity theory is the simplest and most widely accepted theory explaining the variation of exchange rates a unit of any given currency should be able to buy the same quantity of goods in all countries The theory of purchasing-power parity is based on a principle called the law of one price.
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According to the law of one price, a good must

PURCHASING-POWER PARITY

If the law of one price were not true, unexploited profit opportunities would exist and arbitrage would occur (arbitrage is a fancy term for trading or buying low and selling high).. If arbitrage occurs, eventually prices that differed in two markets would necessarily converge, and exchange rates move to ensure that a currency would have the same purchasing power in all countries.
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Purchasing-Power Parity
The purchasing-power parity theory is the simplest and most widely accepted theory explaining the variation of currency exchange rates.

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Purchasing-Power Parity Summary of Basic Logic

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If the law of one price were not true, unexploited profit opportunities would exist. The process of taking advantage of differences in prices in different markets is called arbitrage.

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Purchasing-Power Parity Basic Logic

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If arbitrage occurs, eventually prices that differed in two markets would necessarily converge.

According to the theory of purchasing-power parity, a currency must have the same purchasing power in all countries and exchange rates move to ensure that. 4/30/12
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Purchasing-Power Parity Implications

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If the purchasing power of the dollar is always the same at home and abroad, then the exchange rate of dollar cannot change and real exchange rate is equal to 1.

The nominal exchange rate between the currencies of two countries must reflect the different price levels in those countries. 4/30/12
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Implications of Purchasing-Power Parity

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When the central bank prints large quantities of money, the money loses value both in terms of the goods and services it can buy and in terms of the amount of other currencies it can buy.

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Limitations of Purchasing-Power Parity

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Many goods are not easily traded or shipped from one country to another. Tradable goods are not always perfect substitutes when they are produced in different countries.

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Why real exchange rates are not always equal one?

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Why real exchange rates are not always equal one?

Many goods are not easily traded or shipped from one country to another. Tradable goods are not always perfect substitutes when they are produced in different countries.

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Summary
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Net exports are the value of domestic goods and services sold abroad minus the value of foreign goods and services sold domestically. Net foreign investment is the acquisition of foreign assets by domestic residents minus the acquisition of domestic assets by

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Summary
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An economys net foreign investment always equals its net exports. An economys saving can be used to either finance investment at home or to buy assets abroad.

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Summary
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The nominal exchange rate is the relative price of the currency of two countries. The real exchange rate is the relative price of the goods and services of two countries.

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Summary
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When the nominal exchange rate changes so that each domestic currency unit buys more foreign currency, the domestic currency is said to appreciate or strengthen. When the nominal exchange rate changes so that each currency unit buys less foreign currency, the

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Summary
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According to the theory of purchasing-power parity, a unit of currency should buy the same quantity of goods in all countries. The nominal exchange rate between the currencies of two countries should reflect the countries price levels in those

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