Government Spending, Monetary Policy, and the Real Exchange Rate

GATE Working Paper No. 1139

30 Pages Posted: 3 Jan 2012 Last revised: 16 Mar 2012

See all articles by Hafedh Bouakez

Hafedh Bouakez

HEC Montréal

Aurélien Eyquem

University of Lyon 2 - Groupe d'Analyse et de Théorie Economique (GATE)

Date Written: March 2012

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 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.

Keywords: Real exchange rate, public spending shocks, small open economy, sticky prices, monetary policy

JEL Classification: F31, F41

Suggested Citation

Bouakez, Hafedh and Eyquem, Aurélien, Government Spending, Monetary Policy, and the Real Exchange Rate (March 2012). GATE Working Paper No. 1139. Available at SSRN: https://ssrn.com/abstract=1978823 or http://dx.doi.org/10.2139/ssrn.1978823

Hafedh Bouakez (Contact Author)

HEC Montréal ( email )

3000, chemin de la Côte-Sainte-Catherine
Montréal, Québec H3T 2A7
Canada
1-514-340-7003 (Phone)
1-514-340-6469 (Fax)

Aurélien Eyquem

University of Lyon 2 - Groupe d'Analyse et de Théorie Economique (GATE) ( email )

93, chemin des Mouilles
Ecully, 69130
France

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