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.