A Macroeconomic Consequence of Foreign Direct Investment: The Welfare Economics of Industrial Hollowing

doi:10.4236/tel.2012.24076

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Theoretical Economics Letters, 2012, 2, 412-417

http://dx.doi.org/10.4236/tel.2012.24076 Published Online October 2012 (http://www.SciRP.org/journal/tel)

A Macroeconomic Consequence of Fore ign Direct

Investment: The Welfar e Economics of

Industrial Hollowing

Masayuki Otaki

Institute of Social Science, University of Tokyo, Tokyo, Japan

Email: [email protected]

Received June 21, 2012; revised July 20, 2012; accepted August 17, 2012

ABSTRACT

This article considers macro and welfare economic implications concerning foreign direct investment under a flexible

exchange rate system. There are serious conflicts between foreign-invested firms and their home country as a whole.

Although lower wages incentivize firms to obtain foreign direct investment, such a movement harms the welfare of the

home-country’s economy in the following ways. First, an increase in unemployment in the home country worsens the

economy’s welfare as proved by Otaki [1]. Second, an appreciation in the real exchange rate, which is induced by the

transfer of earned profits in foreign countries to the home country, reduces the value of profits in terms of domestic

goods. We prove that such an appreciation entirely cancels the benefit from the cost reduction that originates from the

foreign direct investment in lower-wage countries. In the end, only the downturn in employment circumstance remains.

In this sense, the glut of foreign direct investment is harmful and, some coordination is required between firms and the

government of the home country.

Keywords: Macroeconomics of Foreign Direct Investment; Industrial Hollowing; Exchange Rate Appreciation;

Leakage of Effective Demand

1. Introduction

Although, according to the neoclassical trade theory that

deals with a barter economy under perfect competition, it

seems natural and efficient for a higher-wage and capi-

tal-abundant country to export her real capital, such con-

ventional wisdom cannot apply to a monetary economy

in which idle resources (specifically labor forces) are

prevalent even if every price adjusts flexibly, as proved

by Otaki [1-3]. Based on Otaki [4], this article analyzes

the macro and welfare economic consequences of foreign

direct investment of a small and monetary economy un-

der a flexible exchange rate system.

There are numerous discussions concerning foreign

direct investment. Caves [5] argues that foreign direct

investment involves a bundle of capital, technology, and

management skills. Hood and Young [6] and Caves [7]

regard multi-national company as a device of internalize-

ing such firm-specific skills via economizing various

transaction costs. However, these discussions stay in analy-

ses concerning the behavior of each individual firm.

There is no guarantee that higher efficiency within indi-

vidual firms leads to enhance social welfare of the nation

as a whole, specifically in the dynamic monetary econ-

omy1.

Foreign direct investment causes serious conflicts be-

tween capital-exporting firms and their home country.

Such conflicts come from the fact that the foreign direct

investment deprives the home country of employment

opportunities and reduces the effective demand in the

home country. Such a process is cumulative and self-en-

forcing2.

In addition, lower-wage countries, where employees

are not well-associated and do not have the wage-bar-

gaining power against their employer, ceteris paribus,

attracts foreign direct investment seeking more profits.

However, under the flexible exchange rate system, the

transfer of earned profits to the home country appreci-

ates the real exchange rate, as long as savings in the

home country are insensitive to the real exchange rate.

1Applying the two by two model of the barter economy, MacDougall

[8] and Kemp [9] proved that if a capital-exporting country is large

enough to manipulate the interest rate via controlling the volume o

exported capital, she can gain additional welfare. This is an application

of the optimal tariff theorem. Such discussions belong to a quite dif-

ferent context from our theory that deals with the monetary economy

characterized by the flexible exchange rate.

2Kahn [10] carefully distinguishes the home investment from the for-

eign direct investment, when he calculates the employment multiplier.

His discussion clearly indicates that an opposite effect to the home

economy’s employment exists in these two capital investments.

M. OTAKI 413

Thus, the additional profits that are sent from the lower-

wage country are entirely absorbed by such an appre-

ciation.

This phenomenon is a type of fallacy of composition.

That is, although the real exchange rate is an exogenous

variable for each firm, it is endogenous for the home

country as a whole, and it is realigned by the synchro-

nized profits transfer of foreign direct invested firms.

Accordingly, as long as domestic savings are insensitive

to the real exchange rate, the social benefits of foreign

direct investment are absorbed by the appreciation of the

exchange rate.

In sum, the stagnant and cumulative effect of foreign

direct investment remains only in the home country. Such

investment increases unemployment and results in a re-

duction of the effective demand among other effects. We

shall prove that such economic consequences worsen the

resource allocation of the home country in the sense of

Pareto. That is, differing from the classical barter econ-

omy, industrial hollowing is a serious problem in the

monetary economy.

The structure of this paper is as follows. In Section 2,

we construct a macroeconomic model of a small open

country in which the international movement of real cap-

ital is perfect (without any restriction). Section 3 ad-

dresses the welfare implication of foreign direct invest-

ment. Section 4 contains brief concluding remarks.

2. The Model

2.1. The Structure of the Model

We consider a small open economy under a flexible ex-

change rate system based on a standard two-periods over-

lapping generations (OLG) model. The world economy

consists of two economies: the home country and the

foreign country. The home country is very small relative

to the foreign country and the behavior of the home-

country’s industries never affects its counterpart’s eco-

nomic conditions, such as the real GNP.

The home country has two industries: the mobile and

tradable industry (industry a) which can freely change its

location and the immobile and non-tradable industry

(industry b). Each industry consists of differentiated

goods within the interval [0, 1]. Each firm monopolisti-

cally produces its differentiated good. The technology is

identical for all firms regardless of the country or Indus-

try to which each belongs. A unit labor produces a unit

good. That is, the labor productivity is assumed to be

unity for all firms. Furthermore, individuals can partici-

pate with work only when he/she is young.

There is an asymmetry in the nominal wage determi-

nation. In the home country, the nominal wage is deter-

mined by the following two-step game developed by

Otaki [1]. In the first stage, each employer decides its

pricing strategy and employment policy to maximize its

profits. The second stage determines the nominal wage in

accordance with the asymmetric Nash bargaining solu-

tion between the employer and his ensured employees.

In the foreign country, there is no bargaining power

for employees, and the nominal wage keeps to the mini-

mum reservation level. Thus, seeking more profit, all

firms belonging to the mobile and tradable industry (in-

dustry a) move their factories to the foreign country as

soon as international capital movement is permitted. This

is the definition of industrial hollowing in our model.

Furthermore, for simplicity, we assume that the foreign

country is unable to produce good a. In addition, since

every good is differentiated, a firm can segregate the

domestic and foreign markets, and thus, a price dis-

crimination policy is possible. This fact implies that the

purchasing power parity theory never holds concerning

exchange rate determination.

Finally, for simplicity, both governments keep the real

money supply constant. Seigniorage is consumed by both

industries (a and b) in the same proportion as in the pri-

vate sectors.

2.2. Optimization Problems of Economic Agents

2.2.1. Individuals

We assume that every individual has the following utility

function.







121 2

10,1,

iaibi

ki ki

uccc c

cc c

cczz



























 



(1)

where i denotes the aggregate consumption during the

ith stage of life, ki

c is the aggregate consumption of

industry k’s goods during the ith stage of life, and





is the consumption of good z that belongs to in-

dustry k. a is the disutility of labor, and



is a defini-

tion function that takes the value unity when employed

and zero when unemployed.

To solve this optimization problem, we need three steps.

First, given the expenditure of k industry’s goods





kaorb, we maximize with respect to





As the second step, since ki

cecomes a function of ki

need to maximize

 

iaiai bibi

ccycy



 





 

with respect to under the given total real spending

during period , .

M. OTAKI

414

The final step is the maximization of

 

112 2

cycy





with respect to under the lifetime budget constraint.

The first step leads us the following demand function:

 



d,,

ki ki

kikiki ki

cz y

Ppzzy



























(2)

where yki is the nominal expenditure for goods k. Since

the equilibrium is symmetric, without the loss of general-

ity, we can set

iaibi

PP Pi

Hence, the second step of the maximization becomes



max ,

.., .

yai bi

iaibiii

styyy yP

 

The solution is

ai bi

yy (3)

By using (3), the final maximization is expressed by



max ,

.. ,

Yyy

styyy yP







(4)

where y is the nominal income earned when the em-

ployee is young, and



is the inflation rate. Equation

(4) leads us to the Keynes’ type aggregate consumption

of the young generation. That is,

1.ycy (5)

Substituting Equation (5) and the lifetime budget con-

straint into Equation (4), we obtain the following indirect

utility function concerning the consumption stream:





12 1

,1.

lll

IU PP YPP

AyAcc





 









(6)

The superscript denotes the home and

foreign country. From Equation (6), we obtain the nomi-

nal reservation wage during period t as



,ll hf

1Rl l



WAP







. (7)

2.2.2. Employers

longing to industry a faces the identical demand function

   

pz pz





 

at at

cz cz



 

 

　 (8)

where





clhf

e and foreig

is the demand for good within a

the homn country, respectively.





yl hf

denotes the real effective demand of country l during

ddition, let us define the real exchange rate

e by

period t. In a



where E is the nominal exchange rate.

ermination as the

fol

We regard the production-wage det

lowing two-stage game developed by Otaki [1]. First,

an employer determines the employment and price level

so as to maximize its profits. Second, an employer and a

certain member of individuals, who have been ensured

employment, negotiate the nominal equilibrium wage in

accordance with the asymmetric Nash bargaining solu-

tion of which the threaten point is



Since the production function iwe cas linear, n sepa-

denote as

te a firm’s profit maximization into the domestic and

foreign markets. Since these problems are essentially

identical, for avoiding the duplication of elementary cal-

culation, we confine ourselves to the domestic market

problem.

Let us



the bargaining power of an em-

pllioyer. Then the equibrium nominal wage of industry a

in the domestic labor market is determined as







hRh h

WW pz



 .3

at tat (9)

By following Equation (9), the profit

fir

function of each

m within industry a is represented by









πhdRhh







z (10)

Maximizing (10) with respect to, we obtain

at att at

zpzWc







erninge following optimal-pricing rule conc the domes-

tic market regardless of the strength of the bargaining

power





1,,.

pz tz













(11)

Thus, every firm offers the same price regardless of

we obtain the optimal-

pri

e industry to which it belongs.

In the foreign country market,

cing rule via the same procedure as



1,,.

pz tz













(12)

Combining Equations (11) and (12) with (7), we ob-

3For the precise procedure for solving this bargaining problem, see

Otaki [1].

It is clear from Equations (2) and (3) that every firm be-

M. OTAKI 415

tain the world-common equilibrium inflation rate *



*1c



















. (13)

Substituting Equations (11) and (12) into (10), the equi-

librium aggregate profit function

is obtained as

π.

at ttt

yey











(14)

It is apparent from Equation (14) that all factories be-

longing to the mobile industry a move from the home

country where 10



, to the foreign country where



. We defin international capital movement

ustrial hollowing.

e such an

as ind

out bequest

um condition for the foreign exchange

2.3. Market Equilibrium

2.3.1. The Foreign Exchange Market

From the property of the OLG model with

motive, the domestic savings for foreign currency should

be always equal to the sum of the expenditure of the for-

eign old generation and the government toward industry

a plus the wage payments to foreign employees who

work in industry a.

Thus, the equilibri

the stationary state is



EW ey

cy y







 





(15)

where a

is expressed as

ayey

y

 (16)

The left-hand side of Equation (15), is the net foreign

currency savings of the home country. The right-hand

side of this equation is the sum of profits earned in the

foreign country.

In addition, from Equation (11), we obtain











EW (17)

Substituting Equations (16) and (17) into (15) and re-

arranging the terms, we finally obtain the following equa-

tion concerning the equilibrium condition for the foreign

exchange market:









ccc















. (18)

2.3.2. The Aggregate Goods Ma rket

Next we examine the aggregate goods mark

librium condition is defined as

et. The equi-



hh a





ycyy m



 









 



















where

(19)





hab

yyy

P) in terms of t

is the home country’s re

(not GDhe price of a (mobile) industry’s

goods. The terms in the first bracket of the RHS of the

above equation express the total consumption of the

r generation in

al GNP

younge the home country. Note that we

must deduct the real wage payments

EW y

to the foreign country from the real GNP k

to calcu-

late the real disposable income.

The second term is the sum oe government’s and

the older generation’s expenditures in terms of the home

t surplus.

f th

currency4. The terms in the second bracket correspond to

the home-country’s current accoun

cyy















is the real export of the home-country firms (the surplus

of trade balance).

2ey





o asset-accumulation motive in this

model, the terms inside the second bracket takes value

ngly, com-

represents the surplus of the capital account.

Since there is n

zero, as indicated by Equation (15). Accordi

bining with (16) and (19), the aggregate goods market is

cleared when

hh a

ycyy m









 



. (20)

By using Equation (15), (20) can be rewritten as

yey

cy eym





































(21)

To summarize, we have two endogenous variables





and two structural Equations (14) and (20) with

4We here assume that domestic money is credible in the sense of Otaki

[4], and that the current prices are not affected by a change in the no-

minal money supply. Furthermore, the nominal money supply obeys

the rule that the real money supply m is kept constant. That is, the

government’s budget constraint is . gis the real

wasteful

1mg











overnmen

enditure.

M. OTAKI

416



in to

two exogenous variable. Thus, the model is

closed. Substituting (18) (21) and solving on h

we obtain





ccc





















From (18) and (22), we can also ascertain













( 22)

dm 

ative

with the

pos-

3. Welfare Implicatoreign Dir

Investment

In this section, we analypositive and norm

implications of foreign ent by the com

pa in

case for a dis

able income

ions of F

ze the

direct investm

ect

rative statics of the model. First, we beg

n increase in the foreign country’s real

lon he r the foreign co

From the maximization condition of a firm that

gs to industry a, t

be-

untryoutput fo

proportionately increases with

. However, we must

note that the foreign country’s disposable income

always appears as the product with the real exchange rate

e in market equilibrium conditions (18) and (21).

Accordingly, it is apparent that, regardless of the level

of the foreign disposable income

, as long as the real

exchange rate properly adjusts so that the product

is kept constant, there is no substantial effect on the do-

mestic economy. This property implies that even if the

foreign country upturns and provides the foreign-in-

vested firm with additional business opportunities, such a

possibility immediately disappears because of the appre-

ciation of the real exchange rate. This appreciation is

caused by the simultaneous moves of firms to transfer

would-be profits to the home country. Thus, foreign di-

rect investment never cultivates new business opportuni-

ties per se. This assertion is also clear from the fact that

(22) does not contain the term

ey .

However, as seen in the second term of (21), which

never appears without foreign direct investment, we can

ascertain that there is a negative effect on the domestic

effective demand. This is because foreign direct invest-

ment deprives the home country of the domestic em-

ployment opportunities and because a part of the effect-

tive demand flows to the foreicountry as wage pay-

nts to foreign employees.

Thus, there emerges the coexistence of higher unem-

ployment and continuous appreciation of the real ex-

change rate in an industrially hollowed country together

with its surrounding economies’ growth. Although such a

tendency is observed in many advanced countries, it is

especially prominent in Japan.

Next, let us analyze the welfare-economic implication

of foreign direct investment. Since, from Equations (6)

and (13), the net welfare gain is proportionate to the real

total sales after deducting the real reservation wage pay-

ment, the total indirect utility is proportionate to the do-

mestic real GNP h

. (Note that the distribution ratio

between the real reservation wage to residuals is





.)

Accordingly, it is apparent from (21) that the equilib-

rium real GNP is always higher in the case without in-

dustrial hollowing. This is because, as previously dis-

cussed, a leak of the domestic effective demand, which

comes from wage payments to the foreign country, exists.

Thus, the industriaollowing brings about a negative

welfare effect for the home country. This tendency

l h

be-

comes more prominent as the monopolistic power of the

tradable and mobile industry (industry a) declines, and





takes a lower value since such decline results in

higher wage payments to foreign countries.

Hence, foreign direct investment under a flexible ex-

change rate system harms the economic welfare of the

home country as a whole, although it is a rational behav-

ior for individual firms. As such, an economic conflict

emerges between the home country and internationalized

individual firms.

econd, let us consider the effectiveness concerning

the domestic fiscal-monetary policy. From (21

), it is clear

that the multiplier of our fiscal-monetary policy is smaller

than in the case of a closed economy without foreign

direct investment. That is,



1c



1

ccc





































Such a decline in the effectiveness of aggregate man-

agement policies also comes from the fact that there is a

leakage of the domestic eff

ective demand via wage pay-

ment to the foreign country. Together with a weakening

monopolistic power (lower value of 1





beco

), the decline in

the power of fiscal-monetary policymes more seri-

ous. This is also because higher wage payments are re-

quired.

industrial hollowing occurs whenever wage is

try. Foreign direct invest-

m as long as the macro-

However, industrial hollowing under a flexible exchange

4. Concluding Remarks

This article analyzed macroeconomic effects concerning

foreign direct investment in a small open country under a

flexible exchange rate system with a rigorous dynamic

microeconomic foundation. Obtained economic cones-

quences are not so optimistic for industrial hollowing.

First,

cheaper than in the home coun

ment is beneficial for each fir

economic circumstances are kept intact despite of such a

collective movement, which we call industrial hollowing.

M. OTAKI

417

monetary policy,

ous consideration

ployment Policy,” Economics Letters, Vol. 102, No. 1,

2009, pp. 1-3. doi:10.1016/j.econlet.2008.08.003

rate is harmful to the home-country’s economy. Massive

transfer of earnings to the home country appreciates the

real exchange rate enough to cancel out the spuriou

nefits from foreign direct investment.

There remains only the contraction of employment

opportunities in the home country. The unemployment

caused by industrial hollowing reduces the real effective

demand and real disposable income via the multiplier

effect. Thus, the economic welfare is deteriorated by in-

dustrial hollowing, as proved by Otaki [1]. In other

words, there is a serious political conflict between a na-

tion state and internationalized firms.

Second, the effectiveness of the fiscal-

hich is defined by the value of the fiscal multiplier, is

weakened by industrial hollowing. Such a difficulty comes

from the leakage of the effective demand that accompa-

nies industrial hollowing. That is, the domestic effective

demand leaks to the foreign country via the wage pay-

ments. It results in lowering the value of the fiscal multi-

plier. The decline in the power of the aggregate demand

management should be taken into seri

henever we think of the current severe constraint con-

cerning fiscal discipline, although such a discussion is

partly beyond the scope of this paper.

To summarize, libertarianism concerning foreign di-

rect investment is never preferable. Some regulations based

on common sense and coordination between the mone-

tary authority and internationalized firms are urgently re-

quired.

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and the Welfolicy,” Economics

e Dynamically Extende

are-Improving Fiscal P

Letters, Vol. 96, No. 1, 2007, pp. 23-29.

doi:10.1016/j.econlet.2006.12.005

[3] M. Otaki, “A Pure Theory of Aggregate Price Determina-

tion,” Theoretical Economics Letters, Vol. 1, No. 3, 2011,

pp. 122-128. doi:10.4236/tel.2011.13026

[4] M. Otaki, “A Keynesian Model of a Sma

omy under a Flexible Exchange Ra

ll Open Econ-

te System,” Theoreti-

ica, Vol. 38,

cal Economics Letters, Forthcoming.

[5] R. E. Caves, “International Corporation: The Industrial

Economics of Foreign Investment,” Econom

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