Government spending, monetary policy, and the real exchange rate

Hafedh Bouakez and Aurélien Eyquem

Journal of International Money and Finance, 2015, vol. 56, issue C, 178-201

Abstract: Both the traditional Mundell-Fleming-Dornbusch framework and standard dynamic general-equilibrium models with complete financial markets predict that an unanticipated increase in public spending in a given country appreciates its currency in real terms. This prediction, 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 expenditure, the long-term real interest rate rises less than the country's debt elastic interest-rate premium. As a result, the long-term real interest rate differential vis-a-vis the rest of the world falls, leading the domestic currency to depreciate in real terms. 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: 2015
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Citations: View citations in EconPapers (33)

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Related works:
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 (2012)
Working Paper: Government Spending, Monetary Policy, and the Real Exchange Rate (2011)
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Persistent link: https://EconPapers.repec.org/RePEc:eee:jimfin:v:56:y:2015:i:c:p:178-201

DOI: 10.1016/j.jimonfin.2014.09.010

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