Government Spending, Monetary Policy, and the Real Exchange Rate

Aurélien Eyquem (1) , Hafedh Bouakez (2, 3)

1 GATE Lyon Saint-Étienne - Groupe d'Analyse et de Théorie Economique Lyon - Saint-Etienne
2 CIRPEE - Centre interuniversitaire sur le risque, les politiques économiques et l'emploi
3 HEC Montréal - HEC Montréal

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 signifi...cant 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.

Mots clés: Real exchange rate; public spending shocks; small open economy; sticky prices; monetary policy

Domaines: Economies et finances

Aurélien Eyquem, Hafedh Bouakez. Government Spending, Monetary Policy, and the Real Exchange Rate. 2012. ⟨halshs-00655972v2⟩