Effects of Government Purchases in Open Economies: Empirical Evidence and Predictions of a Dynamic General Equilibrium Model With Nominal Rigidities

Estimates of effects of changes in government purchases are provided, for the G7 countries, during the post-Bretton Woods era. Empirically, a country-specific increase in government purchases tends to raise domestic and foreign output and consumption; domestic and foreign output multipliers of government purchases exceed unity, in the short to medium run. A quantitative dynamic-optimizing general equilibrium model of a two-country world with money and sticky prices and wages is presented, and that model is examined for its ability to explain the above empirical regularities. Standard RBC models with flexible prices and wages fail to generate large government purchases multipliers, unless labor supplies are highly elastic (with respect to the wage rate). The paper shows that this changes when sticky prices and/or wages are assumed: even when labor supplies are inelastic, the model here generates sizable government purchases multipliers. However, irrespective of the degree of nominal rigidity, the predicted response of foreign real activity to country-specific changes in government purchases is weak. The model here predicts that a rise in government purchases, in a given country induces a depreciation of that country's exchange rate, as seems consistent with the data.