Fiscal shocks and the real exchange rate: evidence from an outpost of textbook open-economy macroeconomics

David Fielding

Oxford Economic Papers, 2014, vol. 66, issue 2, 491-515

Abstract: Recent empirical research into the macroeconomic effects of fiscal policy shocks has generated a ‘puzzle’. Both Keynesian and Real Business Cycle models predict that a fiscal expansion will lead to a real exchange rate appreciation. However, in almost all the individual countries that have been studied, positive shocks to government spending cause the real exchange rate to depreciate. Recent theoretical work suggests that this unexpected result might reflect incomplete international financial market integration. The country where the incomplete markets assumption is least plausible is New Zealand, because of its integration into the Australian financial system. We show that in New Zealand there is no puzzle, and the standard textbook result still holds. Our counter-factual results are consistent with the argument that the puzzle is to be explained by an absence of complete international financial market integration in most parts of the world.

Date: 2014
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