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Government Spending, Monetary Policy, and the Real Exchange Rate

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  • Hafedh Bouakez
  • Aurélien Eyquem

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 effective 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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Bibliographic Info

Paper provided by CIRPEE in its series Cahiers de recherche with number 1212.

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Date of creation: 2012
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Handle: RePEc:lvl:lacicr:1212

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Keywords: Incomplete markets; monetary policy; public spending shocks; real exchange rate; small open economy; sticky prices;

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References

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  1. Jordi Galí & Mark Gertler & J. David López-Salido, 2003. "Markups, Gaps, and the Welfare Costs of Business Fluctuations," Working Papers 45, Barcelona Graduate School of Economics.
  2. Morten O. Ravn & Stephanie Schmitt-Grohe & Martin Uribe, 2007. "Explaining the Effects of Government Spending Shocks on Consumption and the Real Exchange Rate," Economics Working Papers ECO2007/23, European University Institute.
  3. Enders, Zeno & Müller, Gernot & Scholl, Almuth, 2010. "How do Fiscal and Technology Shocks affect Real Exchange Rates? New Evidence for the United States," CEPR Discussion Papers 7732, C.E.P.R. Discussion Papers.
  4. Robert Kollmann, 2010. "Government Purchases and the Real Exchange Rate," Open Economies Review, Springer, vol. 21(1), pages 49-64, February.
  5. 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.
  6. Nooman Rebei & Hafedh Bouakez, 2004. "Why Does Private Consumption Rise After a Government Spending Shock?," Computing in Economics and Finance 2004 20, Society for Computational Economics.
  7. Bouakez, Hafedh & Chihi, Foued & Normandin, Michel, 2014. "Fiscal policy and external adjustment: New evidence," Journal of International Money and Finance, Elsevier, vol. 40(C), pages 1-20.
  8. Kim J. Ruhl, 2008. "The International Elasticity Puzzle," Working Papers 08-30, New York University, Leonard N. Stern School of Business, Department of Economics.
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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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