GALSTYAN AND LANE
spending and the long-run real exchange rate. In particular, the role of government in-
vestment has been neglected, with the literature cited above focusing on the role of gov-
ernment consumption. The distinction is important, since we wish to highlight that gov-
ernment consumption and government investment may be expected to have different
effects on the evolution of relative price levels. While an increase in government con-
sumption is typically modelled as increasing the relative demand for nontradables and
thereby leading to real appreciation, a long-run increase in public investment has an am-
biguous impact on the real exchange rate. While an increase in public investment that de-
livers a productivity gain in the tradables sector may generate real appreciation through
the Balassa-Samuelson mechanism, if public investment disproportionately raises pro-
ductivity in the nontradables sector, it may actually lead to real depreciation. Moreover,
if productivity is increased symmetrically in both sectors, there is no long-run impact on
the relative price of nontradables and the real exchange rate.
We illustrate these mechanisms by laying out a two-sector small open economy model
that incorporates both government consumption and government investment as poten-
tial influences on the real exchange rate. In our empirical work, we examine trade-
weighted real effective exchange rates and the relative price of nontradables for a panel
of nineteen advanced economies over 1980-2004.2 Our results confirm that an increase
in government consumption appreciates the real exchange rate and increases the relative
price of nontradables. Consistent with the model, the results for government investment
are more ambiguous, with government investment leading to real depreciation for some
country groups but with a zero effect for others.
The rest of the paper is organized as follows. Section 2 describes the theoretical frame-
work, while Section 3 describes the data and reports the empirical results. Some conclu-
sions are offered in Section 4.
2. Model
In this section, we lay out an adapted version of the standard two-sector small open
economy model (Obstfeld and Rogoff 1996). The production functions for traded and
nontraded goods are respectively
YT = AT F (LT , KT ) = (AT Z αZ )LTL KTK (1)
2The set of advanced economies are Australia, Austria, Belgium, Canada, Denmark, Finland, France,
Germany, Greece, Ireland, Italy, Japan, Netherlands, Norway, Portugal, Spain, Sweden, United Kingdom,
United States.