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Article Excerpt
IN RECENT YEARS, there has been a resurgence of interest in the long-run behavior of real exchange rates. Along one dimension, the role of an "undervalued" real exchange rate in accelerating development has been much debated (Rodrik 2007). A connected issue is the role of the real exchange rate in facilitating the emergence of large global imbalances, together with the implications of the accumulated net foreign asset position for the long-run value of the real exchange rate (Lane and Milesi-Ferretti 2002, 2004, Galstyan 2007, Ricci, Milesi-Ferretti, and Lee 2008).
Within Europe, the long-run behavior of the real exchange rate has a special significance in the context of European Monetary Union (EMU). First, bilateral real exchange rate movements among the member countries take the form of inflation differentials, which cannot be properly interpreted without a view on the long-run drivers of the real exchange rate. Second, in relation to those countries that plan to join EMU, the projected path for the long-run real exchange rate matters in determining the correct entry rate for the nominal exchange rate and the timing of adopting the single currency.
In modeling the long-run behavior of the real exchange rate, the primary focus in the literature has been on factors such as productivity and the net foreign asset position. However, government spending has also been identified as a potential influence on the long-run real exchange rate. In the most comprehensive study, Ricci, Milesi-Ferretti, and Lee (2008) study the long-run determinants of the real effective exchange rate over 1980-2004 in a panel of 48 countries (combining advanced economies and emerging market economies) and find that government consumption is highly significant. Moreover, the estimated coefficient is economically large: a 1 percentage point increase in the ratio of government consumption to GDP is associated with 3 percentage points appreciation of the real effective exchange rate.
The role of government consumption has previously been highlighted by Froot and Rogoff (1991), who postulate that increases in government consumption tend to increase the relative price of nontradables, since government consumption is concentrated on nontradables. Further empirical support is provided by De Gregorio, Giovannini, and Wolf (1994) and Chinn (1999), who also find that increases in government consumption are associated with real appreciation. (1)
Our goal in this paper is to expand the analysis of the relation between government spending and the long-run real exchange rate. In particular, the role of government investment has been neglected, with the literature cited above focusing on the role of government consumption. The distinction is important, since we wish to highlight that government consumption and government investment may be expected to have different effects on the evolution of relative price levels. While an increase in government consumption is typically modeled as increasing the relative demand for nontradables, thereby leading to real appreciation, a long-run increase in public investment has an ambiguous impact on the real exchange rate. While an increase in public investment that delivers a productivity gain in the tradables sector may generate real appreciation through the Balassa-Samuelson (Balassa 1964, Samuelson 1964) mechanism, if public investment disproportionately raises productivity in the nontradables sector, it may actually lead to real depreciation. Moreover, if productivity is increased symmetrically in both sectors, there is no long-run impact on the relative price of nontradables and the real exchange rate.
We illustrate these mechanisms by laying out a two-sector small open-economy model that incorporates both government consumption and government investment as potential influences on the real exchange rate. In our empirical work, we examine trade-weighted real effective exchange rates and the relative price of nontradables for a panel of 19 advanced economies over 1980-2004. (2) Our results confirm that an increase in government consumption appreciates the real exchange rate and increases the relative price of nontradables. Consistent with the model, the results for government investment are more ambiguous, with government investment leading to real depreciation for some country groups but with a zero effect for others.
The rest of the paper is organized as follows. Section 1 describes the theoretical framework, while Section 2 describes the data and reports the empirical results. Some conclusions are offered in Section 3.
1. MODEL
In this section, we lay out an adapted version of the standard two-sector small open-economy model (Obstfeld and Rogoff 1996). The production functions for traded and nontraded goods are respectively
[MATHEMATICAL EXPRESSION NOT REPRODUCIBLE IN ASCII], (1)
[MATHEMATICAL EXPRESSION NOT REPRODUCIBLE IN ASCII], (2)
where L and K stand for labor and capital, while Z stands for the public capital stock. (3) That is, we assume that total factor productivity in each sector is a composite of a sector-specific term ([A.sup.*.sub.T], [A.sup.*.sub.N]) and the level of public capital. (4) Accordingly, productivity in both sectors is enhanced by a larger stock of public capital, but we allow for the impact to be potentially different across sectors (if [[alpha].sub.z] [not equal to] [[beta].sub.z]). We assume that [[alpha].sub.L] + [[alpha].sub.K] = 1, but [[beta].sub.L] + [[beta].sub.K] 1. That is, we incorporate a fixed factor of production (normalized to 1) in the nontraded sector such that the production function in that sector exhibits diminishing returns to labor and capital. (5) The price of the traded goods is equal to world price of the goods and is normalized to 1, while the price of nontraded goods is PN.
The accumulation equations for the private capital stocks in the traded and non-traded sectors are given by
[DELTA][K.sub.T] = [I.sup.K.sub.T] - [delta][K.sub.T], (3)
[DELTA][K.sub.N] = [I.sup.K.sub.N] - [delta][K.sub.N], (4)
where I denotes the level of gross investment and [delta] is the depreciation rate. The public capital stock evolves according to
[DELTA]Z = [I.sup.Z] - [delta]Z. (5)
We assume that private capital formation in the traded and nontraded sectors only requires the traded goods as an input, while public capital formation uses only the nontraded goods as an input. (6) The representative household has an instantaneous utility function over the goods defined as
C = [C.sup.1-[gamma].sub.T] [C.sup.[gamma].sub.N]/[(1 - [gamma]).sup.1-[gamma]] [[gamma].sup.[gamma]], (6)
with the implication that optimal household expenditure shares on traded and nontraded goods are fixed at (1 - [gamma]) and [gamma], respectively, with a unit elasticity of the relative consumption of nontradables in relation to the relative price of nontradables.
The welfare-based price index consistent with equation (6) is
P = [P.sup.[gamma].sub.N]. (7)
We assume that the price of the nontraded goods in the rest of the world is fixed and normalized to 1, such that changes in P correspond to changes in the real exchange rate.
The government runs a balanced budget, levying lump-sum taxes equal to the value of total government consumption and government investment
T = [G.sub.T] + [P.sub.N]([G.sub.N] + [I.sup.Z]), (8)
where [G.sub.T] and [G.sub.N] are the...
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