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Government Purchases and the Real Exchange Rate

  • Robert Kollmann

    ()

Recent empirical research documents that an exogenous rise in government purchases in a given country triggers a persistent depreciation of its real exchange rate - which raises an important puzzle, as standard macro models predict an appreciation of the real exchange rate. This paper presents a simple model with limited international risk sharing that can account for the empirical real exchange rate response. When faced with a country-specific rise in government purchases, local households experience a negative wealth effect; they thus work harder, and domestic output increases. Under balanced trade (financial autarky) this supply-side effect is so strong that the terms of trade worsen, and the real exchange rate depreciates. In a bonds-only economy, an increase in government purchases triggers a real exchange rate depreciation, if the rise in government purchases is sufficiently persistent and/or labor supply is highly elastic.

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File URL: http://hdl.handle.net/10.1007/s11079-009-9148-2
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Article provided by Springer in its journal Open Economies Review.

Volume (Year): 21 (2010)
Issue (Month): 1 (February)
Pages: 49-64

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Handle: RePEc:kap:openec:v:21:y:2010:i:1:p:49-64
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