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Fiscal Policy and Real Exchange Rate

Fiscal Policy and Real Exchange Rate
Datum: July 12, 2012 Links:Paper SSRN
Referent: Santanu Chatterjee, Associate Professor of Economics (University of Georgia)

Government spending on infrastructure has recently increased sharply in many emerging-market economies.This paper examines the mechanism through which public infrastructure spending affects the dynamics of the real exchange rate. Using a two-sector dependent open economy model with intersectoral adjustment costs, we show that government spending generates a non-monotonic U-shaped adjustment path for the real exchange rate with sharp intertemporal trade-offs. The effect of government spending on the real exchange rate depends critically on (i) the sectoral composition of public spending, (ii) the underlying financing policy, (iii) the sectoral intensity of private capital in production, and (iv) the relative sectoral productivity of public infrastructure. In deriving these results, the model also identifies conditions under which the predictions of the neoclassical open economy model can be reconciled with empirical regularities, namely the intertemporal relationship between government spending, private consumption, and the real exchange rate.