The Exchange Rate and Wages: How They Affect Capital Investment

Productivity is an important factor in determining the living standards of a country’s citizens, and Canada’s productivity gap with the United States has received considerable attention. There are many elements driving productivity, only some of which can be controlled by any one country. This study looks at one important productivity driver—investment in physical capital (for example, machinery and equipment), and presents results to show the effect of the exchange rate and real wage on this investment in a typical developed economy (a weighted average of 17 OECD countries). The results show that a currency depreciation has a significant negative effect on investment in physical capital, especially in service sectors. These results imply that policies that increase the real wage costs of firms—such as policies that inhibit labour market flexibility—may hinder investment and future growth.