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The effects of fiscal shocks on the exchange rate in the EMU and differences with the USA

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  • Francisco Castro
  • Daniel Garrote

Abstract

We analyse the impact of government spending shocks on the real effective exchange rate and net exports in the Euro Area within a standard structural VAR framework. We show that higher government spending leads to real exchange rate appreciation and to a fall in net exports, jointly with lower primary budgetary surpluses, in line with the “twin deficits” hypothesis. Our results are consistent both with the home-bias hypothesis of public expenditure and with public investment contributing to generating relative productivity gains in the traded goods sector. Contrary to what is observed in the Euro Area, the real effective exchange rate depreciates in the USA in response to higher government spending. Such different behaviour is attributed to two factors, namely the leading role of the US dollar as a “safe haven” currency and the countercyclical behaviour of discretionary government spending in the USA. Copyright Springer-Verlag Berlin Heidelberg 2015

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  • Francisco Castro & Daniel Garrote, 2015. "The effects of fiscal shocks on the exchange rate in the EMU and differences with the USA," Empirical Economics, Springer, vol. 49(4), pages 1341-1365, December.
    • Handle: RePEc:spr:empeco:v:49:y:2015:i:4:p:1341-1365
    DOI: 10.1007/s00181-015-0925-z
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    More about this item

    Keywords

    Euro Area; SVAR; Fiscal shocks; Effective exchange rates; Relative prices; Twin deficits; Fiscal multipliers; E62; H30;
    All these keywords.

    JEL classification:

    • E62 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - Fiscal Policy; Modern Monetary Theory
    • H30 - Public Economics - - Fiscal Policies and Behavior of Economic Agents - - - General

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