Working Paper: CEPR ID: DP7427
Authors: Robert Kollmann
Abstract: Recent empirical research documents that an exogenous rise in government purchases in a given country triggers a persistent depreciation of its real exchange rate - which raises an important puzzle, as standard macro models predict an appreciation of the real exchange rate. This paper presents a simple model with limited international risk sharing that can account for the empirical real exchange rate response. When faced with a country-specific rise in government purchases, local households experience a negative wealth effect; they thus work harder, and domestic output increases. Under balanced trade (financial autarky) this supply-side effect is so strong that the terms of trade worsen, and the real exchange rate depreciates. In a bonds-only economy, an increase in government purchases triggers a real exchange rate depreciation, if the rise in government purchases is sufficiently persistent and/or labor supply is highly elastic.
Keywords: government purchases; limited international risk sharing; real exchange rate
JEL Codes: E62; F36; F41
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Government Purchases (G) (H59) | Depreciation of Real Exchange Rate (RER) (F31) |
| Government Purchases (G) (H59) | Negative Wealth Effect (W) (E21) |
| Negative Wealth Effect (W) (E21) | Increased Labor Supply (L) (J20) |
| Increased Labor Supply (L) (J20) | Increased Domestic Output (Y) (E23) |
| Increased Domestic Output (Y) (E23) | Deterioration of Terms of Trade (ToT) (F14) |
| Deterioration of Terms of Trade (ToT) (F14) | Depreciation of Real Exchange Rate (RER) (F31) |