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 it does not stimulate economic activity. A fiscal contraction, instead, does not alter the exchange rate, but it reduces output. We develop these insights in a simple two-sector model of a small open economy with downward nominal wage rigidity. We then use alternative strategies to identify government spending shocks in a large cross-country data set with quarterly observations for up to 38 countries for the period from the early 1990s to 2018. For our baseline, we focus on the countries in the euro area. They lack a flexible exchange rate via-à-vis each other, so they provide an ideal testing ground for the theory. In our empirical specification, we allow positive and negative shocks to have asymmetric effects, and we are indeed able to reconcile Keynesian and Classcial views regarding the short run: negative shocks are recessionary, positive shocks are absorbed by exchange-rate appreciation. In line with the predictions of the model, we find that initial conditions matter, too. Recessions make positive shocks expansionary; in periods of high inflation, negative shocks affect the exchange rate. The evidence for countries outside the euro area lends further support to the predictions of the model.

JEL Classification: E62, F41, F44