Abstract
By using the Survey of Professional Forecasters, we provide new evidence on the open-economy effects of government spending, focusing on a well-known puzzle in the literature, that the real exchange rate depreciates in response to a fiscal expansion. Much of government spending is well anticipated over a one year horizon. Once news and surprise shocks are treated as different shocks, there is no depreciation puzzle for news shocks while it is still there for surprise shocks. Fiscal foresight seems to lie at the heart of the different exchange rate responses to news and surprise shocks, depending on the timing of the anticipated budget adjustment following the shock. Indeed, the results are broadly consistent with the prediction of a DSGE model with spending reversals.
Highlights
While there is still a widespread disagreement among economists about the effects of government spending shocks on consumption, empirical VAR evidence strongly supports, at least with US data, the view that increases in government spending lead, in advanced economies with flexible exchange rates, to a depreciation of the real domestic currency.12 The result stands in sharp contrast with standard theory, which predicts that fiscal policy expansions appreciate the real exchange rate
In the model consumption and interest rates move in opposite directions following a spending shock, whereas the empirical responses have the same sign
Once news and surprise shocks are treated as different shocks, there is no depreciation puzzle for news shocks
Summary
While there is still a widespread disagreement among economists about the effects of government spending shocks on consumption, empirical VAR evidence strongly supports, at least with US data, the view that increases in government spending lead, in advanced economies with flexible exchange rates, to a depreciation of the real domestic currency (see Kim and Roubini, 2008, Corsetti and Muller, 2006, Monacelli and Perotti, 2007, Ravn, SchmittGrohe and Uribe, 2007, and Enders, Muller and Scholl, 2011). The result stands in sharp contrast with standard theory, which predicts that fiscal policy expansions appreciate the real exchange rate. While there is still a widespread disagreement among economists about the effects of government spending shocks on consumption, empirical VAR evidence strongly supports, at least with US data, the view that increases in government spending lead, in advanced economies with flexible exchange rates, to a depreciation of the real domestic currency (see Kim and Roubini, 2008, Corsetti and Muller, 2006, Monacelli and Perotti, 2007, Ravn, SchmittGrohe and Uribe, 2007, and Enders, Muller and Scholl, 2011).. Ravn, Schmitt-Grohe and Uribe, 2007, show that, with deep habits, the increase in aggregate demand triggered by government spending leads to a reduction of the domestic markup, which in turn makes domestic output less expensive, i.e. the real exchange rate depreciates. If, when a positive government spending shock occurs, agents anticipate such ”spending reversals”, the real long term interest rate may fall, leading to a real depreciation of the exchange rate, as well as an improvement of the external balance
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