The Composition of Government Spending and the Real Exchange Rate



THE COMPOSITION OF GOVERNMENT SPENDING AND THE REAL EXCHANGE RATE

Equations (1) to (12) together with the first-order conditions for private consumption
and private investment and the profits of the non-traded sector form the system.

Our primary interest is in the long-run behavior of the real exchange rate. Accord-
ingly, we focus on the steady-state solution of the model. In order to obtain an analytical
solution, we assume no depreciation.6 We initially solve for a benchmark steady state in
which the levels of net foreign assets and government consumption are zero (in order to
obtain a closed-form solution). Then we log-linearize the system around this benchmark,
in order to examine the sensitivity of the steady-state real exchange rate to shifts in the
steady-state values of the exogenous variables.

In the benchmark steady state, the relative price of non-traded goods is7 8

PN =


ηLN


1-βK

αz βz

Z 1-ακ  1-βκ


(13)


In the next stage, we log-linearize around this steady state and solve the system. The

« ∙ .      . Γ ∙             ∙ i .   . . I ∙ . ∣1  .   .     ...    .      ∙    . « 1  .    .1.     1        ..      « . тЧ          ^r~t          ∙ « 1

equation of primary interest is the one governing the real exchange rate, P = γPN, with
the relative price of non-traded goods given by

1 — Л?
-

(14)


P3N = -AN + :j-----AT + μ0(rB + [GN - GT]) + μ1Z

1 - αK

where hatted variables denote percentage deviations from the steady-state values.9 Equa-
tion (
14) shows that an improvement in productivity in the nontraded sector generates
real depreciation and a decline in the relative price of nontradables, while an increase in
productivity in the traded sector generates real appreciation and an increase in the rel-
ative price of nontradables, where these forces operate according to the classic Balassa-
Samuelson mechanism.10 The other key coefficients are

αL(1 - βL - βK)(1 - Y)
αL(1 - Y) + βLY

>0


(15)


and


(1-jβκ2αz.--(1.-..ακ}βz.


<=> 0


(16)


6With depreciation the model has to be solved numerically.

7See Appendix A for the set of steady state equations.

8The parameter η is a complex product of the underlying parameters:    η =

αK αK   βK      __βK

αLαK-αK r 1-ακ 1-βκ β-1βκ 1-βK .

9The equations governing sectoral output and consumptiond dynamics are given in Appendix B.

10A symmetric increase in productivity in both sectors generates real appreciation if the nontraded sector
is less capital intensive than the traded sector (
βK < αK).



More intriguing information

1. The fundamental determinants of financial integration in the European Union
2. Multi-Agent System Interaction in Integrated SCM
3. Testing Gribat´s Law Across Regions. Evidence from Spain.
4. The name is absent
5. Fiscal Sustainability Across Government Tiers
6. Effort and Performance in Public-Policy Contests
7. Agricultural Policy as a Social Engineering Tool
8. KNOWLEDGE EVOLUTION
9. Financial Markets and International Risk Sharing
10. Bird’s Eye View to Indonesian Mass Conflict Revisiting the Fact of Self-Organized Criticality
11. Response speeds of direct and securitized real estate to shocks in the fundamentals
12. Fortschritte bei der Exportorientierung von Dienstleistungsunternehmen
13. The name is absent
14. Who runs the IFIs?
15. The name is absent
16. The Impact of Optimal Tariffs and Taxes on Agglomeration
17. The urban sprawl dynamics: does a neural network understand the spatial logic better than a cellular automata?
18. The name is absent
19. Detecting Multiple Breaks in Financial Market Volatility Dynamics
20. The name is absent