Foreign Direct Investment and Hysteresis: Short Term Rescue or Long Term Sentence?

Foreign direct investment is often regarded by countries with balance of payments problems as a potential source of salvation. The consequences of a rise in foreign direct investment are analysed within a two-country, four-product, six-asset small macro model and is shown to have two distinct and offsetting effects. The first effect improves the balance of payments and prevents devaluation. The second effect depreciates the real exchange rate and raises the return on capital. In both cases net international debt increases. If foreign direct investment is withdrawn, a consequence of there being multiple equilibria in the model is that the domestic country may get stuck in a debt-trap. Similarly hysteric behaviour is displayed by the real exchange rate.