Effects of Exchange Rate Volatility on Export Diversity: The Role of Production Constraints

We develop a model of product-variety adjustment in which a firm's choice of the number of varieties exported to each market (export scope) reflects a trade-off between short-run responses to demand shocks associated with exchange rate fluctuations and the costs of making investment in the production capacity. Firms reduce their export scopes when markets suffer negative demand shocks but, in the case of positive shocks, are unable to expand them adequately, due to insufficient pre-investment in production capacity. As a result, we observe asymmetric export responses to exchange rate fluctuations, and negative effect of exchange rate volatility on exports. Data on Chinese exporters support our predictions.

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