Government Spending and the Real Exchange Rate: a Cross - Country Perspective

In this paper we study, from an empirical point of view, the determinants of the real exchange rate (RER). Relative to the vast previous literature on this topic we aim to distinguish the impact of two important components of government expenditure—public investment and transfers—on the RER, which has usually been neglected. Using panel cointegration techniques, we assess the relevance of those variables in the determination of the RER for a wide set of countries from 1980 to 2009. Our results suggest that changes in either government transfers or public investment have an impact on the RER in emerging economies. On one hand, transfers tend to appreciate the RER because they induce an increase in the relative demand for nontraded goods. On the other, an increase in public investment generates an RER depreciation. This result can be explained by the fact that, in this case, there is an increase in the relative productivity in the nontraded sector of the economy. We also study the effect of countries’ net external assets position on the RER and find that it differs markedly between developed and developing countries: this variable has a significant effect only in the case of developing economies.