International Trade and Macroeconomic Dynamics with Heterogeneous Firms

We develop a stochastic, general equilibrium, two-country model of trade and macroeconomic dynamics. Productivity differs across individual, monopolistically competitive firms in each country. Firms face some initial uncertainty concerning their future productivity when making an irreversible investment to enter the domestic market. In addition to the sunk entry cost, firms face both fixed and per-unit export costs. Only a subset of relatively more productive firms export, while the remaining, less productive firms only serve their domestic market. This microeconomic structure endogenously determines the extent of the traded sector and the composition of consumption baskets in both countries. Exogenous shocks to aggregate productivity, sunk entry costs, and trade costs induce firms to enter and exit both their domestic and export markets, thus altering the composition of consumption baskets across countries over time. The microeconomic features have important consequences for macroeconomic variables. Macroeconomic dynamics, in turn, feed back into firm level decisions, further altering the pattern of trade over time. Our model generates deviations from purchasing power parity that would not exist absent our microeconomic structure with heterogeneous firms. It provides an endogenous, microfounded explanation for a Harrod-Balassa-Samuelson effect in response to aggregate productivity differentials and deregulation. In addition, the deviations from purchasing power parity triggered by aggregate shocks display substantial endogenous persistence for very plausible parameter values, even when prices are fully flexible.