Government Spending, Downward Nominal Wage Rigidity, and Exchange Rate Dynamics?

Abstract

In this paper, we show that government spending impacts the real exchange rate asymmetrically, depending on whether spending is raised or cut. We first consider an extension of the small open economy model put forward by Schmitt-Grohe and Uribe (2016) in order to illustrate the mechanism. The key feature of the model is that wages are downwardly rigid and that monetary policy is generally unable to fully offset the effect of this nominal rigidity. We show that an expansion of government spending causes a real appreciation, while a reduction of government spending causes a real depreciation. But, importantly, the depreciation is generally smaller than the appreciation. In a second step, we estimate local projections using quarterly data for 38 advanced and emerging market economies, covering the period from the early 1990s to 2017. We find that positive government spending shocks appreciate the real exchange rate. Negative spending shocks have no significant effect. This result is robust across alternative identification schemes.

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Work in Progress
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