We thank two anonymous referees and Harris Dellas for useful comments. P. Basu acknowledges a research leave from Durham University. R. Kollmann thanks the National Bank of Belgium and the EU Commission for financial support (CEPR project ‘Politics, Economics and Global Governance: The European Dimensions’ funded by the EU Commission under its 7th Framework Programme for Research, Contract No. 217559).
PRODUCTIVE GOVERNMENT PURCHASES AND THE REAL EXCHANGE RATE*
Version of Record online: 19 JUN 2012
© 2012 The Authors. The Manchester School © 2012 John Wiley & Sons Ltd and The University of Manchester
The Manchester School
Volume 81, Issue 4, pages 461–469, July 2013
How to Cite
BASU, P. and KOLLMANN, R. (2013), PRODUCTIVE GOVERNMENT PURCHASES AND THE REAL EXCHANGE RATE. The Manchester School, 81: 461–469. doi: 10.1111/j.1467-9957.2012.02295.x
Manuscript received 28.7.10; final version received 9.8.11.
- Issue online: 18 JUN 2013
- Version of Record online: 19 JUN 2012
Empirical research documents that an exogenous rise in government purchases in a given country triggers a depreciation of its real exchange rate. This raises an important puzzle, as standard macro-theories predict an appreciation of the real exchange rate. We argue that this prediction might reflect the conventional assumption that government purchases are unproductive. Using a simple frictionless model with efficient international risk sharing, we show that the real exchange can depreciate in response to a rise in government purchases, if these purchases increase domestic private sector productivity, and labor supply is highly elastic. Empirically plausible marginal products of government purchases are sufficient to generate this result.