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

Author

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  • Francisco de Castro

    () (Banco de España and European Commission)

  • Daniel Garrote

    () (Banco de España)

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 employ a new database that contains quarterly fiscal variables for the Euro Area as a whole. 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, which turns out to be fully consistent with the “twin deficits” hypothesis. The different components of public spending, namely wage and non-wage consumption expenditure, overall public consumption expenditure and public investment, bring about real appreciations. Our results are therefore also 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 US in response to higher government spending. This discrepancy can ultimately be explained by the reaction of nominal interest rate spreads and the uncovered interest parity condition. The dissimilar reaction of short-term nominal interest rate spreads is attributed to two factors, namely the role of the US dollar as a "safe haven" currency and the countercyclical behaviour of discretionary government spending in the US.

Suggested Citation

  • Francisco de Castro & Daniel Garrote, 2012. "The effects of fiscal shocks on the exchange rate in the EMU and differences with the US," Working Papers 1224, Banco de España;Working Papers Homepage.
  • Handle: RePEc:bde:wpaper:1224
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    Cited by:

    1. Hrvoje Simovic & Milan Deskar-Skrbic, 2013. "Dynamic effects of fiscal policy and fiscal multipliers in Croatia," Zbornik radova Ekonomskog fakulteta u Rijeci/Proceedings of Rijeka Faculty of Economics, University of Rijeka, Faculty of Economics, vol. 31(1), pages 55-78.
    2. Paredes, Joan & Pedregal, Diego J. & Pérez, Javier J., 2014. "Fiscal policy analysis in the euro area: Expanding the toolkit," Journal of Policy Modeling, Elsevier, vol. 36(5), pages 800-823.

    More about this item

    Keywords

    Euro Area; SVAR; fiscal shocks; effective exchange rates; relative prices; twin deficits; fiscal multipliers;

    JEL classification:

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

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