Theoretical Economics Letters, 2012, 2, 412-417
http://dx.doi.org/10.4236/tel.[phone] 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
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
f
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.
C
opyright © 2012 SciRes. TEL

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.
 


11
1
121 2
11
22
1
11
1
0
,,
,
d,
10,1,
cc
iaibi
ki ki
uccc c
cc c
cczz
c













 

(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
c


ki
cz
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


ki
y
kaorb, we maximize with respect to
ki
c


ki
cz
.
As the second step, since ki cecomes a function of ki y,
need to maximize
b
we
 
11
22
iaiai bibi
ccycy

  

 
with respect to under the given total real spending
during period , .
ki
y
i
yi

M. OTAKI 414
The final step is the maximization of
 
1
112 2
cc
cycy 

with respect to under the lifetime budget constraint.
i
The first step leads us the following demand function:
y
 

1
11
1
0
,
Y
d,,
ki
ki ki
ki
ki
kikiki ki
pz
cz y
P
Ppzzy
P













(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

11
22
max ,
.., .
ki
yai bi
i
iaibiii
yy
Y
styyy yP  
The solution is
.
2
i
ai bi
y
yy (3)
By using (3), the final maximization is expressed by

1
12
12
1
max ,
.. ,
i
cc
Yyy
Y
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
12
11
,,
,1.
l
lll
cc
ll
cc
lc
l
AY
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
Rl
t
W
1Rl l

1c
tt
WAP



. (7)
2.2.2. Employers
longing to industry a faces the identical demand function
   
,
22
hf
hf
pz pz
 
 
tt
hf tt
at at
hf
tt
yy
cz cz
PP

 
 
 
(8)
where


,
l
at
clhf
e and foreig
is the demand for good within a
the homn country, respectively.


,
l
t
yl hf
denotes the real effective demand of country l during
ddition, let us define the real exchange rate
t
e by
period t. In a
,
f
tt
td
t
EP
ep 
where E is the nominal exchange rate.
ermination as the
fol
t
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

0,
R
W.
Since the production function iwe cas linear, n sepa-
ra
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



*1 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
th
at att at
zpzWc 

.

h
ai
pz
erninge following optimal-pricing rule conc the domes-
tic market regardless of the strength of the bargaining
power

,

*
1,,.
1
Rh
ht
at
W
pz tz






(11)
Thus, every firm offers the same price regardless of
th
we obtain the optimal-
pri
e industry to which it belongs.
In the foreign country market,
cing rule via the same procedure as

*
1,,.
1
Rf
W
ft
at
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 *

as
1
11
*1c
A 









. (13)
Substituting Equations (11) and (12) into (10), the equi-
librium aggregate profit function
*
π
*
at
h
t
P
is obtained as
*1
*
π.
2
hf at ttt
h
t
yey
P



 
(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
1

. We defin international capital movement
ustrial hollowing.
e such an
as ind
out bequest
um condition for the foreign exchange
in
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

1
*
11
22
R
.
f
ha ii
a
i
EW ey
cy y
p



 


(15)
where a
y
is expressed as
.
2
hf
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
1
1.
ii
a
i
p





R
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:




11
11
22
h
ccc
f
y
ey








. (18)
2.3.2. The Aggregate Goods Ma rket
Next we examine the aggregate goods mark
librium condition is defined as
et. The equi-

1
1
a
i
R
hh a ii
11
2
R
f
f ii
a
i
cy
ey
p


EW
ycyy m

 

p
EW




 









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
Ra
ii
a
i
EW y
p
to the foreign country from the real GNP k
y
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
1
2
R
ha ii
a
i
EW
cyy
p







is the real export of the home-country firms (the surplus
of trade balance).
1
f
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
1
1
hh a
ycyy m 




 


. (20)
By using Equation (15), (20) can be rewritten as
1
11
11
12
.
22
hf
hh
hf
yey
cy
cy eym





y
m














(21)
To summarize, we have two endogenous variables


,
h
ye
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
1
1mg 




g
overnmen
t
ex
p
enditure.

M. OTAKI 416
s

,
f
my
in to
two exogenous variable. Thus, the model is
closed. Substituting (18) (21) and solving on h
y
,
we obtain

1
1
m

1
11
21
ccc 


 
 




From (18) and (22), we can also ascertain
.
11
1
h
yc






( 22)
0.
de
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
f
y
.
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
f
. However, we must
note that the foreign country’s disposable income
f
y
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
f
y
, as long as the real
exchange rate properly adjusts so that the product
f
ey
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
f
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-
me
gn
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
y
. (Note that the distribution ratio
between the real reservation wage to residuals is
11
:1




.)
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
1


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
S
), 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,

1
11
.
1c

1
1
11
21
ccc 


11
1c
















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
s
be
monetary policy,
w
ous consideration
w
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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