Direct investment, hysteresis, and real exchange rate volatility

Abstract

Recent papers by Dixit and others have put forth the argument that real exchange shocks generate a condition of hysteresis in the export entry and exit prices, and that this wedge in prices explains the persistence in the U.S. current account deficit. This article shows that the critical hysteresis bounds for exports are altered dramatically by the additional option to locate manufacturing in the United States. We develop a model that incorporates simultaneously the option to exit from a foreign country along with the option to invest in manufacturing facilities. The numerical simulations provide strong qualifications to the relationship between hysteresis in export prices and the persistence of the current account deficit. J. Japan. Int. Econ., March 1996, 10(1), pp. 12-36. School of Management, Boston University, Boston, Massachusetts 02215. © 1996 Academic Press, Inc.