How do innovation and exchange rate changes affect firms' mode of foreign expansion?

This paper uses a two-country two-firm imperfect competition model where each firm is located in a different country. We study the effects of firms' innovation and exchange rate change on their international expansion choices. As in Petit and Sanna-Randaccio (2000), the market structure is endogenously determined by the subgame perfect Nash equilibrium of a three-stage game that involves three different decisions by the firms: how to expand abroad, how much to invest in R&D, and how much to sell in each country under different market configurations. Since the price of output is directly affected by the exchange rate, we carefully include the impact of an anticipated exchange rate change in the future on firms' current decisions. The results show that an increase in R&D productivity leads firms towards multinational expansion. Furthermore, home currency appreciation also raises the likelihood of FDI by firms. Compared with the results of Petit and Sanna-Randaccio (2000), mixed duopoly is more likely to arise under exchange rate fluctuation in our model.