The Cost of Doing Business Abroad and International Capital Market Equilibrium

Milind Shrikhande
Federal Reserve Bank of Atlanta
Working Paper 97-3
July 1997

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The implications of the costs of doing business in foreign countries for the resulting capital market equilibrium are studied. When transferring capital goods across national boundaries, the costs incurred are quasi-fixed in a one-good, two-country, intertemporal model with complete financial markets. In our model of the international capital market, deviations from purchasing power parity are endogenously generated. The relative price of physical resources located in one country compared to resources located in another is called the "real exchange rate." The outcome of the model-based analysis is an endogenous generation of a mean-reverting real exchange rate in a continuous-time, general equilibrium model of the international capital market. In dynamic equilibrium, the transfer of capital goods between the two countries is found to be infrequent and lumpy in nature as is observed in foreign direct investment.

JEL classification: D51, C61, D90, F30

Key words: quasi-fixed costs, real exchange rates, international capital market equilibrium

The author is a visiting scholar in the Atlanta Fed's research department. He gratefully acknowledges Bernard Dumas for his guidance and insightful suggestions. He thanks Erin Anderson, Cheol Eun, Bruce Kogut, Weishi Liu, Richard Marston, Raman Uppal, and Jiang Wang for many helpful discussions. He also thanks the participants of seminars at The Wharton School, University of Pennsylvania; the University of California at Riverside; McGill University; and the Georgia Institute of Technology, especially Franklin Allen, Vihang Errunza, Sarkis Khoury, David Nachman, Narayanan Jayaraman, and Larry Wall for helpful comments. He also appreciates the comments of discussant Francisco Delgado and chair Jim Lothian at the 1995 NAEFA Meetings. The views expressed here are those of the author and not necessarily those of the Federal Reserve Bank of Atlanta or the Federal Reserve System. Any remaining errors are the author's responsibility.

Please address questions of substance to Milind Shrikhande, School of Management, Georgia Institute of Technology, 755 Ferst Drive, Atlanta, Georgia 30332-0520, 404/894-5109, 404/894-6030 (fax),