Publisher:
LUISS Guido Carli, Department of Economics and Finance, Arcelli Centre for Monetary and Financial Studies, Rome
Abstract:
Contrary to widespread empirical evidence, standard NOEM models imply that the real exchange rate appreciates following an increase in public spending. This paper introduces productive government purchases and shows that the real exchange rate can depreciate after a positive spending shock, thus reconciling the theoretical model with the empirical evidence. Under empirically consistent parameterization, the model implies a depreciation both on impact and in the transition. The transmission mechanism works through an increase in domestic private-sector productivity, spurred by government purchases, which reduce domestic real marginal costs.