Real adjustment of current account imbalances with firms heterogeneity

This paper investigates the impact of a real current account adjustment on terms of trade, aggregate productivity and welfare-based exchange rate in a two-country general equilibrium model. As in Melitz (2003), firms are heterogeneous in productivity and endogenously enter and exit their domestic and export markets. The real adjustment of the current account leads to the increase of Home exports through the intensive and the extensive margins of trade: incumbent firms export more and new exporters endogenously enter the market. In the benchmark case, the extensive margin of trade accounts for about 19% of the overall adjustment and the depreciation of the national currency is lower with respect to models where this margin is not considered. In the literature, the change in the terms of trade is lower when goods are more substituable. This common finding is overturned by the endogenous entry of new exporters. For a given dispersion of productivity across firms, a higher elasticity of substitution reduces the role played by the extensive margin on the adjustment and yields a higher depreciation of the exchange rate