Trade and Foreign Direct Investment: New Theoretical Approach and Empirical Findings for US Exports and European Exports

Trade theory, in the context of economic globalization, is not fully convincing because so far foreign direct investment has not been considered explicitly. The workhorse of modern empirical trade analysis is the gravity model, that however, has only a limited basis in terms of precise derivation of the gravity equation; it is not particularly clear why the domestic GDP figure should be in the export equation. Taking a look at a simple model with two countries producing under Coob Douglas technology we consistently derive that exports depend positively both on the foreign GDP and the GDP of the home country. The empirical error correction model (ECM) approach presented for Germany's export volume to the US, and for US exports to Germany, give clear evidence that there is a positive effect on the real exchange rate, the foreign GDP and the home GDP - more specifically the ratio of home GDP to foreign GDP - on export quantity. US exports to France, Italy, the Netherlands and Spain also produced similar results. The direct real exchange rate elasticities found are - in a standard perspective - higher than in traditional approaches; but it is shown that the elasticity is a positive function of the relative size of the foreign market and the composite export elasticity is below unity or close to unity. Moreover, the new export equation introduced here is also a basis for refined gravity modeling; Mundell Fleming models should also be adequately re-specified. As regards the euro crisis it seems fairly clear that the fiscal multipliers for countries with inward vs. outward FDI look different from the traditional multiplier models.