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Mr. Keynes Meets the Classics: Government Spending and the Real Exchange Rate

Author

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  • Benjamin Born
  • Francesco D’Ascanio
  • Gernot J. Müller
  • Johannes Pfeifer

Abstract

In economies with fixed exchange rates, the adjustment to government spending shocks is asymmetric. A fiscal expansion appreciates the real exchange rate but does not stimulate output. A fiscal contraction does not alter the exchange rate, but lowers output. We develop these insights in a two-sector model of a small open economy with downward nominal wage rigidity. We establish new empirical evidence that supports he predictions of the model along several dimensions: not only does the exchange rate regime shape the fiscal transmission mechanism as predicted by the model – in doing so it also interacts with economic slack and inflation.

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  • Benjamin Born & Francesco D’Ascanio & Gernot J. Müller & Johannes Pfeifer, 2021. "Mr. Keynes Meets the Classics: Government Spending and the Real Exchange Rate," ifo Working Paper Series 352, ifo Institute - Leibniz Institute for Economic Research at the University of Munich.
    • Handle: RePEc:ces:ifowps:_352
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    2. Laurent Ferrara & Luca Metelli & Filippo Natoli & Daniele Siena, 2020. "Questioning the puzzle: Fiscal policy, exchange rate and inflation," Working papers 752, Banque de France.
    3. Kim, Hyeongwoo & Shao, Peng & Zhang, Shuwei, 2023. "Policy coordination and the effectiveness of fiscal stimulus," Journal of Macroeconomics, Elsevier, vol. 75(C).
    4. James Cloyne & Òscar Jordà & Alan M. Taylor, 2023. "State-Dependent Local Projections: Understanding Impulse Response Heterogeneity," Working Paper Series 2023-05, Federal Reserve Bank of San Francisco.
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    6. Mr. Tidiane Kinda & Andras Lengyel & Kaustubh Chahande, 2022. "Fiscal Multipliers During Pandemics," IMF Working Papers 2022/149, International Monetary Fund.
    7. Lukasz Wiktor Olejnik, 2023. "Economic growth and military expenditure in the countries on NATOʼs Eastern flank in 1999–2021," Bank of Estonia Working Papers wp2023-2, Bank of Estonia, revised 09 May 2023.
    8. Ferrara, Laurent & Metelli, Luca & Natoli, Filippo & Siena, Daniele, 2021. "Questioning the puzzle: Fiscal policy, real exchange rate and inflation," Journal of International Economics, Elsevier, vol. 133(C).
    9. Naser Yenus Nuru & Hayelom Yrgaw Gereziher, 2021. "The impacts of public expenditure innovations on real exchange rate volatility in South Africa," WIDER Working Paper Series wp-2021-72, World Institute for Development Economic Research (UNU-WIDER).
    10. Wataru Hirata & Toshitaka Maruyama & Tomohide Mineyama, 2020. "Flattening of the Wage Phillips Curve and Downward Nominal Wage Rigidity: The Japanese Experience in the 2010s," Bank of Japan Working Paper Series 20-E-4, Bank of Japan.
    11. Dr. Matthias Burgert & Philipp Pfeiffer & Werner Roeger, 2021. "Fiscal policy in a monetary union with downward nominal wage rigidity," Working Papers 2021-16, Swiss National Bank.
    12. Ricardo Duque Gabriel & Mathias Klein & Ana Sofia Pessoa, 2023. "The Effects of Government Spending in the Eurozone," Journal of the European Economic Association, European Economic Association, vol. 21(4), pages 1397-1427.
    13. Gancho Ganchev & Ivan Todorov, 2021. "Taxation, government spending and economic growth: The case of Bulgaria," Journal of Tax Reform, Graduate School of Economics and Management, Ural Federal University, vol. 7(3), pages 255-266.
    14. Yoon J. Jo & Sarah Zubairy, 2021. "State dependent government spending multipliers: Downward nominal wage rigidity and sources of business cycle fluctuations," Working Papers 20210127-001, Texas A&M University, Department of Economics.
    15. Olejnik, Łukasz Wiktor, 2023. "Short-run multiplier effects of military expenditures in NATO's Eastern Flank countries in 1999–2021," Journal of Comparative Economics, Elsevier, vol. 51(4), pages 1344-1355.
    16. Mamondi Victor Daniel & Oviedo Jorge & De la Rosa Adolfo, 2023. "El-Déficit-Fiscal-Deteriora-el-Tipo-de-Cambio-Real.-Evidencias-por-medio-de-un-modelo-de-EGDE-para-Argentina," Asociación Argentina de Economía Política: Working Papers 4666, Asociación Argentina de Economía Política.
    17. HSING, Yu, 2021. "Are The Predictions Of The Mundell-Fleming Model Applicable To Argentina?," Applied Econometrics and International Development, Euro-American Association of Economic Development, vol. 21(1), pages 37-48.
    18. Liu, Siming, 2022. "Government spending during sudden stop crises," Journal of International Economics, Elsevier, vol. 135(C).
    19. Ramona Tiganasu & Gabriela Carmen Pascariu & Dan Lupu, 2022. "Competitiveness, fiscal policy and corruption: evidence from Central and Eastern European countries," Oeconomia Copernicana, Institute of Economic Research, vol. 13(3), pages 667-698, September.
    20. Haug, Alfred A. & Sznajderska, Anna, 2024. "Government spending multipliers: Is there a difference between government consumption and investment purchases?," Journal of Macroeconomics, Elsevier, vol. 79(C).
    21. Mario Di Serio & Matteo Fragetta & Emanuel Gasteiger & Giovanni Melina, 2022. "The Euro Area Government Spending Multiplier in Demand- and Supply-Driven Recessions," CESifo Working Paper Series 9678, CESifo.

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    More about this item

    Keywords

    Downward nominal wage rigidity; government spending shocks; exchangerate peg; real exchange rate; nonlinear effects; asymmetric adjustment; depreciation bias;
    All these keywords.

    JEL classification:

    • E62 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - Fiscal Policy; Modern Monetary Theory
    • F41 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - Open Economy Macroeconomics
    • F44 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - International Business Cycles

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