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Do exchange rates affect the capital–labour ratio? Panel evidence from Canadian manufacturing industries

Using industry-level data for Canadian manufacturing industries from 1981 to 1997, we find empirical evidence of a negative relationship between the capital–labour ratio and the user cost of capital relative to the price of labour. A 10% increase in the user cost of the Machinery and Equipment (M&E) relative to the price of labour results in a 3.3% decrease in the M&E–labour ratio in the long run. Assuming complete exchange rate pass-through into imported M&E prices, the maximum effect of a permanent 10% depreciation in the exchange rate is a 1.7% decline in the M&E–labour ratio. This result implies that the cumulative growth of the M&E–labour ratio during the 1991 to 1997 period would have been 2.3 percentage points higher had the dollar not depreciated. This may appear to be significant, but considering both M&E as a share of total capital and the capital share of nominal output are both approximately one-third, in terms of a simple growth accounting framework, the effect on labour productivity is small.