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

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 the 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.

Publication
Journal of Political Economy, revise & resubmit