The Composition of Government Spending and the Real Exchange Rate



THE COMPOSITION OF GOVERNMENT SPENDING AND THE REAL EXCHANGE RATE

1. Introduction

In recent years, there has been a resurgence of interest in the long-run behavior of real
exchange rates. Along one dimension, the role of an “undervalued” real exchange rate
in accelerating development has been much debated (Rodrik 2007). A connected issue is
the role of the real exchange rate in facilitating the emergence of large global imbalances,
together with the implications of the accumulated net foreign asset position for the long-
run value of the real exchange rate (Lane and Milesi-Ferretti 2002 and 2004, Galstyan
2007, Ricci et al 2008).

Within Europe, the long-run behavior of the real exchange rate has a special signif-
icance in the context of European Monetary Union (EMU). First, bilateral real exchange
rate movements among the member countries take the form of inflation differentials,
which cannot be properly interpreted without a view on the long-run drivers of the real
exchange rate. Second, in relation to those countries that plan to join EMU, the projected
path for the long-run real exchange rate matters in determining the correct entry rate for
the nominal exchange rate and the timing of adopting the single currency.

In modelling the long-run behavior of the real exchange rate, the primary focus in
the literature has been on factors such as productivity and the net foreign asset position.
However, government spending has also been identified as a potential influence on the
long-run real exchange rate. In the most comprehensive study, Ricci et al (2008) study
the long-run determinants of the real effective exchange rate over 1980-2004 in a panel of
48 countries (combining advanced economies and emerging market economies) and find
that government consumption is highly significant. Moreover, the estimated coefficient is
economically large: a 1 percentage point increase in the ratio of government consumption
to GDP is associated with a 3 percentage point appreciation of the real effective exchange
rate.

The role of government consumption has previously been highlighted by Froot and
Rogoff (1991), who postulate that increases in government consumption tend to increase
the relative price of nontradables, since government consumption is concentrated on
nontradables. Further empirical support is provided by De Gregorio et al (2004) and
Chinn (1999), who also find that increases in government consumption are associated
with real appreciation.1

Our goal in this paper is to expand the analysis of the relation between government

1There is also an active VAR literature on the short-run relation between fiscal shocks and the real ex-
change rate (Monacelli and Perotti 2006, Ravn, Schmitt-Grohe and Uribe 2007, Beetsma and Giuliodori
2007). Our focus here is on the long-run behaviour of the real exchange rate, which is not addressed in
this literature.



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