The effects of real exchange rates and unit labor costs on foreign direct investment

Abstract

This paper examines the effects of real exchange rates and unit labor costs on foreign direct investment. Our argument is based on a theoretical model, developed by Cushman (1987). The model assumes that a source country's firms simultaneously produce goods at home and in the host country. They sell their output totally in the host country's local markets. With regards to this assumption, we argue that a real depreciation of the host country's currency will lead to a rise in FDI from the source country. A rise in the source country's unit labour costs will cause FDI to increase on the assumption that the substitution effect between capital and labour is weak. Whenever the substitution effect is strong, FDI and unit labour costs can have a negative relationship. To test this argument, we use data from Thailand, Singapore, and the Philippines. The results of this study seem to support only the effects of real exchange rates on FDI.