International transmission of monetary policies: The role of foreign investment and currency substitution

Countries are engaged more and more in investing abroad. In this context, one would be interested to know how the devaluation of a country's currency could affect the level of foreign investment. In addition, agents in many countries want to hold foreign currency for different purposes; thus, domestic inflation is affected not only by domestic economic variables but also by the holding of foreign currency. Hence, it is interesting to investigate how the holding of foreign currency affects domestic inflation in some countries.;Chapter 1 presents the introduction and plan of study of the thesis.;In chapter 2, the effect of the devaluation of the exchange rate on the level of foreign investment is examined in a two-country model of international trade. There are both traded goods and non-traded goods in the two countries, in addition to the public good, which is financed by tariff revenue in the host country. We find that the effect of devaluation on foreign investment comes through the change in the price of non-tradable goods of the host country. Devaluation of the host country's currency increases the tariff revenue, increasing the availability of the public good in the host country. If this increases the price of non-tradable goods, the level of foreign investment increases, too.;In chapter 3, a two-period, two-country, multi-good model of international trade is developed to examine the effect of temporary devaluation on both the contemporaneous and the inter-temporal level of foreign investment from the source country to the host country. The two countries are small, open economies in the goods markets, but are interlinked by foreign investment and by borrowing and lending. It is found that there is no effect of temporary devaluation on contemporaneous foreign investment, but the effect on future foreign investment is positive via the working of the international credit market.;Both monetary and non-monetary factors can influence the inflation of an economy. Among the monetary factors are the domestic money supply and interest rate; among the non-monetary factors are the cost of inputs and the budget deficit. As people in an economy hold more foreign currency, inflation becomes dependent on foreign money holding as well. In chapter 4, besides the effects of other domestic economic variables, the effects of holding foreign currency on Mexican and Peruvian inflation are examined. It is observed that foreign money holding in both countries contributes much to the inflation in those respective countries.