Foreign Direct Investment and Real Exchange Rate Interlinkages

This paper examines theoretically and empirically the relationship between Foreign Direct Investment and the real exchange rate. It is found that in large countries with freely floating currencies, such as the USA, the UK and Japan, causality runs from the real exchange rate to FDI. These results are consistent with the predictions of models of financial behavior. Causality runs both ways in small countries with fixed or quasi fixed currencies, such as the EU countries. These results are consistent with models, which emphasize on trade integration. It is shown that a weaker euro will not have uniform effects on FDI inflows across the unified Europe.