The Effects of Government Spending on Real Exchange Rates: Evidence from Military Spending Panel Data 
Conventional wisdom—as well as mainstream macroeconomic models used by policymakers—suggests that an increase in government spending puts pressure on the domestic currency to appreciate, leading to current account deterioration and to a decrease in consumption through an international risk-sharing condition. This mechanism holds across a wide range of models, including both New Keynesian and neoclassical models.
However, empirical evidence for such a mechanism has not been settled. For example, Corsetti and Müller (2006) and Kim and Roubini (2008) find that in the U.S. data the trade balance improves after a government spending shock, whereas Monacelli and Perotti (2010) and Ravn, Schmitt-Grohé, and Uribe (2012), using data for Australia, Canada, the United Kingdom, and the United States, estimate that a rise in government spending causes a trade deficit, a real depreciation of the domestic currency, and an increase in consumption.
Thus, several questions on the effects of government spending in an open economy remain: First, does government spending cause the domestic currency to appreciate in real terms and does it worsen the current account? Second, do the effects of government spending shocks differ across countries, especially between advanced and developing countries? Third, does the exchange rate regime or the degree of openness to trade affect the transmission mechanism of government spending shocks?
This paper addresses these important questions using a large dataset for 125 countries between 1989 and 2013 and using exogenous variation in international military spending to identify government spending shocks.
Key Findings
- In response to a positive government spending shock, the real exchange rate appreciates on impact, and the effect is significant up to a two-year horizon. After an increase in government spending of 1 percent of GDP, the real exchange rate appreciates by over 3 percent on impact and by up to 5 percent two years after the shock. The effect on the exchange rate is most pronounced in countries with a flexible exchange rate. Moreover, after a positive government spending shock, the current account deteriorates and consumption increases substantially, peaking at about 5 percent after two years.
- The effects of government spending on the real exchange rate and consumption are significantly different between advanced and developing countries. The real exchange rate depreciates significantly by 3 percent in advanced countries, but it appreciates by over 4 percent in developing countries. Consumption increases with government spending in developing countries, but the effect of government spending on consumption is negative and statistically insignificant in developed countries. The current account deteriorates in both groups.
Implications
The authors conclude that significant variation in specific economic conditions and institutional environments across countries leads to very different responses to fiscal shocks of exchange rates, consumption, and current accounts. Therefore, one cannot easily extend evidence from the United States or OECD countries to less-developed economies. The results call for more research on the role of country-specific institutional arrangements in the transmission and propagation of fiscal shocks, and for more use of macro data from developing countries. It remains an open question whether this result can be achieved within a unified model under different, country-specific calibrations or whether instead, one needs completely separate models. The authors also encourage more diversity in data sources used to estimate the effect of fiscal policy on macroeconomic variables.
Abstract
Using panel data on military spending for 125 countries, we document new facts about the effects of changes in government purchases on the real exchange rate, consumption, and current accounts in both advanced and developing countries. While an increase in government purchases causes real exchange rates to appreciate and increases consumption significantly in developing countries, it causes real exchange rates to depreciate and decreases consumption in advanced countries. The current account deteriorates in both groups of countries. These findings are not consistent with standard international business-cycle models. We investigate whether the difference between advanced economies and developing countries in the responses of real exchange rates to spending shocks can be explained by alternative hypotheses.