Working Paper: CEPR ID: DP14073
Authors: Benjamin Born; Francesco Dascanio; Gernot Müller; Johannes Pfeifer
Abstract: In economies with fixed exchange rates, the adjustment to government spending shocks is asymmetric. Expansionary shocks are absorbed by the real exchange rate, contractionary shocks by output. This result emerges in a small open economy model with downward nominal wage rigidity and is supported by new empirical evidence based on panel data from different exchange-rate regimes. The exchange-rate regime, economic slack, inflation, and how spending is financed all matter for the fiscal transmission mechanism in the way predicted by the model. Estimates that fail to distinguish between the effects of positive and negative shocks are subject to a "depreciation bias".
Keywords: Downward nominal wage rigidity; Government spending shocks; Exchange rate peg; Balanced budget; Taxes; Asymmetric adjustment; Depreciation bias
JEL Codes: E62; F41; F44
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| negative government spending shocks (E62) | output contraction (E32) |
| positive government spending shocks (E62) | real exchange rate appreciation (F31) |
| positive government spending shocks (E62) | output (C67) |
| expansionary government spending shocks (E62) | real exchange rate appreciation (F31) |
| contractionary government spending shocks (E62) | output contraction (E32) |
| exchange rate regime (F33) | fiscal transmission mechanism (F42) |
| economic slack (E24) | fiscal transmission mechanism (F42) |
| inflation (E31) | fiscal transmission mechanism (F42) |
| method of financing government spending (E62) | fiscal transmission mechanism (F42) |
| estimates failing to distinguish between positive and negative shocks (C51) | depreciation bias (D15) |