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Investment and the Exchange Rate

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Abstract

This paper investigates the relationship between exchange rate fluctuations and the investment decisions of a sample of Italian manufacturing firms. The results support the view that a depreciation of the exchange rate has a positive effect on investment through the revenue channel, and a negative effect through the cost channel. The magnitude of these effects varies over time with changes in the firm’s external orientation, as measured by the share of foreign sales over total sales and the reliance on imported inputs. Consistent with the predictions of our theoretical framework, the effect of exchange rate fluctuations on investment is stronger for firms with low monopoly power and for those facing a high degree of import penetration in the domestic market. We also provide evidence that the degree of substitutability between domestically-produced and imported inputs influences the effect through the expenditure side.

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