The real exchange rate, the capital stock, and fiscal policy

Abstract

This paper studies the joint determination of aggregate supply, the real exchange rate and the current account in response to changes in government spending, in a model where there is no uncertainty in the aggregate, but where individuals are uncertain about their lives' duration. International capital mobility fixes the steady-state capital stock and aggregate supply in a small country, whereas in a large country the steady-state capital stock is endogenous. An increase in government spending is more likely to generate a real exchange-rate depreciation in a small country, since the loss of wealth associated with cumulated current account deficits does not increase rest-of-the-world spending. In the case of a large country current account deficits are wealth transfers to the rest of the world, and increase foreign spending: thus the normal long-run response is an increase in the relative price of domestic output.