Exchange Rate Movements, Foreign Direct Investment, and Domestic R&D

Abstract

This paper develops a game-theoretical model to investigate heterogeneous firms’ entry mode choice of international expansion. The distinct feature of this paper is that exchange rate, R&D competition, and intra-industry firm heterogeneity are incorporated into the theoretical framework. The possible impact of a firm’s outward foreign direct investment (OFDI) on its R&D spending and other non-OFDI firms’ R&D spending is also examined. Our analytical results indicate that, if host country has lower labor costs, when facing rising domestic labor costs or appreciation of home currency, a firm with lower productivity in production or R&D activity will choose OFDI, whereas the firms with higher productivity will produce at home and export. In addition, our results demonstrate that the impact of OFDI on R&D spending is ambiguous, depending on firm heterogeneity as well as the wage gap between home country and host country.