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Fiscal Policy and the Real Exchange Rate

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  • Santanu Chatterjee
  • Azer Mursagulov

Abstract

Government spending on infrastructure has recently increased sharply in many emerging-market economies. This paper examines the mechanism through which public infrastructure spending affects the dynamics of the real exchange rate. Using a two-sector dependent open economy model with intersectoral adjustment costs, we show that government spending generates a non-monotonic U-shaped adjustment path for the real exchange rate with sharp intertemporal trade-offs. The effect of government spending on the real exchange rate depends critically on (i) the composition of public spending, (ii) the underlying financing policy, (iii) the intensity of private capital in production, and (iv) the relative productivity of public infrastructure. In deriving these results, the model also identifies conditions under which the predictions of the neoclassical open economy model can be reconciled with empirical regularities, namely the intertemporal relationship between government spending, private consumption, and the real exchange rate.

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Bibliographic Info

Paper provided by International Monetary Fund in its series IMF Working Papers with number 12/52.

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Length: 40
Date of creation: 01 Feb 2012
Date of revision:
Handle: RePEc:imf:imfwpa:12/52

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Keywords: Public investment; Government expenditures; Infrastructure; Real effective exchange rates; Resource allocation; exchange rate; real exchange rate; government spending; government spending shocks; fiscal policy; exchange rates; exchange rate dynamics; public spending; real exchange rate dynamics; real exchange rates; fiscal shocks; fiscal spending; tax credit; exchange rate fluctuations; increase in consumption; real exchange rate fluctuations; taxation; real exchange rate movements; fiscal issues; fiscal policy on consumption; exchange rate increases; real exchange rate changes; tax revenues; effective exchange rates; composition of public spending; exchange rate deviations; budget constraint; exchange rate movements; exchange rate changes; structural adjustment; fiscal deficits; public expenditure; tax breaks;

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