This article examines the role of country-specific sources of output and interest rate or exchange rate volatility in driving Foreign Direct Investment (FDI) activities. Building on a dataset with bilateral FDI flows among 24 Organization for Economic Co-operation and Development (OECD) economies over the period 1985–2007, we find that nominal and real volatility strongly deter foreign investments. Output and exchange rate volatility matter in particular for the decision whether to invest in a foreign country in the first place. Interest rate volatility mainly influences the amount of foreign investments.

This paper provides a framework for the analysis of firms' integration strategies that incorporates the endogenous determination of the number of firms that serve foreign markets through exports and the number of multinational firms that choose to engage in horizontal foreign direct investments. The aim of the study is to investigate how differences in firms' integration strategies affect the way productivity and monetary policy shocks spread their effects worldwide. Building on a general equilibrium model in the tradition of the new open economy macroeconomics with national and multinational enterprises, I find that firms' integration strategies play a key role in the international business cycle and they help explain a number of puzzling features in exchange rate data. The paper makes two main contributions. First, it provides an explanation of long-term deviations from purchasing power parity due to changes in the extensive margin of firms serving world markets via exporting and foreign investment that is novel in the literature. Second, it explores optimal monetary policy in a framework with endogenous trade and foreign investments, elucidating an interesting new trade-off between efficiency and volatility. My results show that monetary stabilization, by discouraging entry of new firms, might involve a policy trade-off between the desire to smooth fluctuations in producers' prices and the need to facilitate adjustments in consumers' prices.