Mr. Keynes Meets the Classics: Government Spending and the Real Exchange Rate

79 Pages Posted: 23 Oct 2019 Last revised: 14 May 2021

See all articles by Benjamin Born

Benjamin Born

Frankfurt School of Finance & Management

Francesco D'Ascanio

University of Tuebingen

Gernot J. Müller

University of Tuebingen - Department of Economics

Johannes Pfeifer

University of Cologne

Multiple version iconThere are 2 versions of this paper

Date Written: October 2019

Abstract

In economies with fixed exchange rates, the adjustment to government spending shocks is asymmetric. A fiscal expansion appreciates the real exchange rate, but it does not stimulate economic activity. A fiscal contraction, instead, does not alter the exchange rate, but it reduces output. We develop these insights in a simple two-sector model of a small open economy with downward nominal wage rigidity. We then use alternative strategies to identify government spending shocks in a large cross-country data set with quarterly observations for up to 38 countries for the period from the early 1990s to 2018. For our baseline, we focus on the countries in the euro area. They lack a flexible exchange rate via-à-vis each other, so they provide an ideal testing ground for the theory. In our empirical specification, we allow positive and negative shocks to have asymmetric effects, and we are indeed able to reconcile Keynesian and Classcial views regarding the short run: negative shocks are recessionary, positive shocks are absorbed by exchange-rate appreciation. In line with the predictions of the model, we find that initial conditions matter, too. Recessions make positive shocks expansionary; in periods of high inflation, negative shocks affect the exchange rate. The evidence for countries outside the euro area lends further support to the predictions of the model.

JEL Classification: E62, F41, F44

Suggested Citation

Born, Benjamin and D'Ascanio, Francesco and Müller, Gernot J. and Pfeifer, Johannes, Mr. Keynes Meets the Classics: Government Spending and the Real Exchange Rate (October 2019). CEPR Discussion Paper No. DP14073, Available at SSRN: https://ssrn.com/abstract=3474446

Benjamin Born (Contact Author)

Frankfurt School of Finance & Management ( email )

Adickesallee 32-34
Frankfurt am Main, 60322
Germany

Francesco D'Ascanio

University of Tuebingen ( email )

Wilhelmstr. 19
72074 Tuebingen, Baden Wuerttemberg 72074
Germany

Gernot J. Müller

University of Tuebingen - Department of Economics ( email )

Mohlstrasse 36
D-72074 Tuebingen, 72074
Germany

Johannes Pfeifer

University of Cologne ( email )

Albertus-Magnus-Platz
Cologne, 50923
Germany

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