The Composition of Government Spending and the Real Exchange Rate

GALSTYAN AND LANE

The welfare-based price index consistent with equation (6) is

P = P_N^γ                                 (7)

We assume that that the price of the non-traded good in the rest of the world is fixed and
normalized to 1, such that changes in P correspond to changes in the real exchange rate.

The government runs a balanced budget, levying lump-sum taxes equal to the value
of total government consumption and government investment

T = GT +PN(GN +I^Z)                         (8)

where GT , GN are the levels of public consumption of the traded and nontraded goods
respectively and I^Z is the level of public investment.

Households own the domestic stocks of capital in the traded and nontraded sectors.
There are no inter-sectoral or international capital adjustment costs, so that the return
on capital is equal to the exogenously-fixed world interest rate. In addition, households
own the fixed factor in the nontraded sector and so receive the income accruing to that
factor (the residual claimant on profits in the nontraded sector). Accordingly, households
face the following budget constraint

∆B = rB + r(KT +KN) + w(LT +LN) - (IN^K+IT^K) - CT -PNCN +ΠN -T  (9)

where B is an international bond that pays the fixed real world interest rate r (in terms
of tradables), ΠN = (1 - β_L - β_K)PNYN is the aggregate profit in the nontraded sector
and T is the tax burden.

For simplicity, we assume an inelastic aggregate labor supply. Labor is perfectly inter-
sectorally mobile, such that the equilibrium in the labor market is

LN + LT = L                            (10)

The equilibrium in the non-traded goods sector is

YN = CN + GN + I^Z                        (11)

while the trade balance is determined by

T B = YT - CT - GT - (I_N^K + I_T^K )

<<   4   5   6   7   8   9   10   >>

More intriguing information