The Composition of Government Spending and the Real Exchange Rate

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].

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