Exchange Rate Fluctuations, Plant Turnover and Productivity

In a small open economy fluctuations in the real exchange rate can affect plant turnover, and thus aggregate productivity, by altering the makeup of plants that populate the market. An appreciation of the local currency increases the level of competition in the domestic market as import competition intensifies and export opportunities shrink, forcing less productive plants from the market and compelling new entrants to be more competitive than they otherwise would have been. Depreciations have the opposite effect, as import competition weakens and new export opportunities arise, less competitive plants are able to continue to operate in the market and crowd out new, more productive entrants. This paper develops a dynamic structural model that captures the effect of plantlevel productivity and real exchange rate fluctuations on plant entry and exit decisions in the Canadian agricultural implements industry, and how this, in turn, affects aggregate productivity. The model's dynamic parameters are estimated in two stages. Variable profit parameters and the per-period fixed cost of operation are estimated first using the Nested Pseudo Likelihood (NPL) algorithm, and then the parameters characterizing the distribution of unobserved potential entrant productivity, along with the cost of entry, are estimated in a second stage using the Method of Simulated Moments (MSM). Finally, simulations of the model are used to investigate the effects of shocks to the exchange rate process on aggregate industry productivity.