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Keywords:

  • E62;
  • F31;
  • F41
  • government consumption;
  • government investment;
  • real exchange rate

We show that the composition of government spending influences the long-run behavior of the real exchange rate. We develop a two-sector small open-economy model in which an increase in government consumption is associated with real appreciation, while an increase in government investment may generate real depreciation. Our empirical work confirms that government consumption and government investment have differential effects on the real exchange rate and the relative price of nontradables.