Government Spending, Monetary Policy, and the Real Exchange Rate

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.