Government Spending, Monetary Policy, and the Real Exchange Rate

Hafedh Bouakez and Aurélien Eyquem

Cahiers de recherche from CIRPEE

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.

Keywords: Incomplete markets; monetary policy; public spending shocks; real exchange rate; small open economy; sticky prices (search for similar items in EconPapers)
JEL-codes: F31 F41 (search for similar items in EconPapers)
Date: 2012
New Economics Papers: this item is included in nep-mon and nep-opm
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (5)

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Related works:
Journal Article: Government spending, monetary policy, and the real exchange rate (2015)
Working Paper: Government Spending, Monetary Policy, and the Real Exchange Rate (2015)
Working Paper: Government Spending, Monetary Policy, and the Real Exchange Rate (2012)
Working Paper: Government Spending, Monetary Policy, and the Real Exchange Rate (2012)
Working Paper: Government Spending, Monetary Policy, and the Real Exchange Rate (2011)
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Persistent link: https://EconPapers.repec.org/RePEc:lvl:lacicr:1212

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