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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.

Suggested Citation

  • Hafedh Bouakez & Aurélien Eyquem, 2011. "Government Spending, Monetary Policy, and the Real Exchange Rate," Working Papers 1139, Groupe d'Analyse et de Théorie Economique Lyon St-Étienne (GATE Lyon St-Étienne), Université de Lyon.
  • Handle: RePEc:gat:wpaper:1139
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    Cited by:

    1. Stéphane Auray & Aurélien Eyquem & Paul Gomme, 2016. "A Tale Of Tax Policies In Open Economies," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 57, pages 1299-1333, November.
    2. Dennis Bonam & Jasper Lukkezen, 2013. "Government Spending Shocks, Sovereign Risk and the Exchange Rate Regime," Tinbergen Institute Discussion Papers 13-212/VI, Tinbergen Institute, revised 09 Jan 2013.
    3. Stijn Claessens & M. Ayhan Kose, 2017. "Asset prices and macroeconomic outcomes: A survey," CAMA Working Papers 2017-76, Centre for Applied Macroeconomic Analysis, Crawford School of Public Policy, The Australian National University.
    4. Kim, Soyoung, 2015. "Country characteristics and the effects of government consumption shocks on the current account and real exchange rate," Journal of International Economics, Elsevier, vol. 97(2), pages 436-447.
    5. Gnocchi, Stefano & Hauser, Daniela & Pappa, Evi, 2016. "Housework and fiscal expansions," Journal of Monetary Economics, Elsevier, vol. 79(C), pages 94-108.
    6. Rose Cunningham & Christian Friedrich & Kristina Hess & Min Jae Kim, 2017. "Understanding the Time Variation in Exchange Rate Pass-Through to Import Prices," Discussion Papers 17-12, Bank of Canada.
    7. Stéphane Auray & Aurélien Eyquem & Paul Gomme, 2016. "A Tale Of Tax Policies In Open Economies," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 57, pages 1299-1333, November.

    More about this item

    Keywords

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

    JEL classification:

    • F31 - International Economics - - International Finance - - - Foreign Exchange
    • F41 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - Open Economy Macroeconomics

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