The Composition of Government Spending and the
Real Exchange Rate*
Vahagn Galstyan Philip R. Lane
IIIS, Trinity College Dublin IIIS, Trinity College Dublin
and CEPR
July 2008
Abstract
We show that the composition of government spending influences the long-run
behaviour of the real exchange rate. We develop a two-sector small open economy
model in which an increase in government consumption is associated with real ap-
preciation, while an increase in government investment may generate real deprecia-
tion. Our empirical work confirms that government consumption and government
investment have differential effects on the real exchange rate and the relative price
of nontradables.
Keywords: government consumption, government investment, real exchange
rate
JEL Codes: E62, F31, F41
* We gratefully acknowledge the financial support of the Irish Research Council for Humanities and Social
Sciences. Lane’s work on this project has also benefited from a Government of Ireland Research Fellowship.
Email: [email protected], [email protected].