Government Purchases and the Real Exchange Rate: A Comment

Abstract

The conventional international RBC model and also the traditional Keynesian model predict that an increase in government purchase results in an appreciation of the real exchange rate (Backus et al. 1994). Data show the opposite. Kolmann’s present paper addresses this government purchase-real exchange rate puzzle. He develops a series of micro based models to establish the central point that limited risk sharing is fundamental to resolve this puzzle. The main features of Kollmann’s static baseline model are as follows: (i) there is an extreme form of financial market incompleteness (trade balance is zero), (ii) all intermediate goods are internationally traded while the final good is not, (iii) the nontraded final good uses a mix of foreign and home produced intermediate goods with a local home bias in the technology, (iv) traded intermediate goods are produced with only labour using a CRS technology, (v) exogenous wasteful government purchases are financed by lump-sum taxes, (vi) wage and prices are flexible. In this environment, an increase in home government purchase gives rise to a negative wealth effect. Consumption and leisure being normal goods decrease in demand. People work harder and home production increases. This positive supplyside effect causes real exchange rate to depreciate via the depreciation of terms of trade. This effect is exacerbated if there is greater risk aversion or higher labour supply elasticity. Kollmann also demonstrates that introduction of sticky prices and wages and extending the model to multiperiods does not alter this central result. Kollmann shows that under full risk sharing the effect of government purchase on real exchange rate is exactly opposite to what happens in an incomplete risk sharing environment. Full risk sharing means that the real exchange rate equals the ratio of the marginal utilities of home goods to foreign goods. An adverse wealth effect of an increase in government purchase on home consumption raises the marginal utility of home consumption which means an appreciation of the real exchange rate contradicting the stylized facts. The punch-line is that incompleteness of the asset market is fundamental for resolving this puzzle. Open Econ Rev (2010) 21:65–67 DOI 10.1007/s11079-009-9154-4