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Government Spending, Monetary Policy, and the Real Exchange Rate

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  • Hafedh Bouakez

    ()
    (HEC Montréal and CIRPÉE, 3000 chemin de la Côte-Sainte-Catherine, Montréal, Québec, Canada H3T 2A7.)

  • Aurélien Eyquem

    ()
    (Université de Lyon, Lyon, F-69007, France ; Ecole Normale Supérieure de Lyon, Lyon, F-69007, France ; CNRS, GATE Lyon St Etienne, Ecully, F-69130, France ; and GREDI, Canada)

Abstract

A robust prediction across a wide range of open-economy macroeconomic models is that an unanticipated increase in public spending in a given country appreciates it currency in real terms. This result, however, contradicts the findings of a number of recent empirical studies, which instead document a significant and persistent depreciation of the real exchange rate following an expansionary government spending shock. In this paper, we rationalize the findings of the empirical literature by proposing a small-open-economy model that features three key ingredients : incomplete and imperfect international financial markets, sticky prices, and a not-too-aggressive monetary policy. The model predicts that in response to an unexpected increase in public expenditures, the risk-adjusted long-term real interest rate falls, causing the real exchange rate to depreciate. We establish this result both analytically, within a special version of the model, and numerically for the more general case.

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Paper provided by Groupe d'Analyse et de Théorie Economique (GATE), Centre national de la recherche scientifique (CNRS), Université Lyon 2, Ecole Normale Supérieure in its series Working Papers with number 1139.

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Date of creation: 2011
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Handle: RePEc:gat:wpaper:1139

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Keywords: Real exchange rate; public spending shocks; small open economy; sticky prices; monetary policy.;

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  1. Jordi Galí & Mark Gertler & J. David López-Salido, 2005. "Markups, gaps and the welfare costs of business fluctuations," Economics Working Papers 836, Department of Economics and Business, Universitat Pompeu Fabra.
  2. Merz, Monika, 1995. "Search in the labor market and the real business cycle," Journal of Monetary Economics, Elsevier, vol. 36(2), pages 269-300, November.
  3. Hafedh Bouakez & Nooman Rebei, 2007. "Why does private consumption rise after a government spending shock?," Canadian Journal of Economics, Canadian Economics Association, vol. 40(3), pages 954-979, August.
  4. Ravn, Morten O. & Schmitt-Grohé, Stephanie & Uribe, Martín, 2007. "Explaining the Effects of Government Spending Shocks on Consumption and the Real Exchange Rate," CEPR Discussion Papers 6541, C.E.P.R. Discussion Papers.
  5. Kollmann, Robert, 2009. "Government Purchases and the Real Exchange Rate," CEPR Discussion Papers 7427, C.E.P.R. Discussion Papers.
  6. Enders, Zeno & Müller, Gernot J. & Scholl, Almuth, 2008. "How do fiscal and technology shocks affect real exchange rates? New evidence for the United States," CFS Working Paper Series 2008/22, Center for Financial Studies (CFS).
  7. Kim J. Ruhl, 2008. "The International Elasticity Puzzle," Working Papers 08-30, New York University, Leonard N. Stern School of Business, Department of Economics.
  8. Hafedh Bouakez & Foued Chihi & Michel Normandin, 2011. "Fiscal Policy and External Adjustment: New Evidence," Cahiers de recherche 1123, CIRPEE.
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Cited by:
  1. Jasper Lukkezen & Dennis Bonam (VU and Tinbergen), 2014. "Government spending shocks, sovereign risk and the exchange rate regime," CPB Discussion Paper 263, CPB Netherlands Bureau for Economic Policy Analysis.
  2. Dennis Bonam & Jasper Lukkezen, 2013. "Government spending shocks, sovereign risk and the exchange rate regime," Working Papers 14-01, Utrecht School of Economics.

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