DP7427 Government Purchases and the Real Exchange Rate

Author(s): Robert Kollmann
Publication Date: August 2009
Keyword(s): government purchases, limited international risk sharing, real exchange rate
JEL(s): E62, F36, F41
Programme Areas: International Macroeconomics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=7427

Recent empirical research documents that an exogenous rise in government purchases in a given country triggers a persistent depreciation of its real exchange rate - which raises an important puzzle, as standard macro models predict an appreciation of the real exchange rate. This paper presents a simple model with limited international risk sharing that can account for the empirical real exchange rate response. When faced with a country-specific rise in government purchases, local households experience a negative wealth effect; they thus work harder, and domestic output increases. Under balanced trade (financial autarky) this supply-side effect is so strong that the terms of trade worsen, and the real exchange rate depreciates. In a bonds-only economy, an increase in government purchases triggers a real exchange rate depreciation, if the rise in government purchases is sufficiently persistent and/or labor supply is highly elastic.