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The effects of fiscal shocks on the exchange rate in the EMU and differences with the USA

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Abstract

We analyse the impact of government spending shocks on the real effective exchange rate and net exports in the Euro Area within a standard structural VAR framework. We show that higher government spending leads to real exchange rate appreciation and to a fall in net exports, jointly with lower primary budgetary surpluses, in line with the “twin deficits” hypothesis. Our results are consistent both with the home-bias hypothesis of public expenditure and with public investment contributing to generating relative productivity gains in the traded goods sector. Contrary to what is observed in the Euro Area, the real effective exchange rate depreciates in the USA in response to higher government spending. Such different behaviour is attributed to two factors, namely the leading role of the US dollar as a “safe haven” currency and the countercyclical behaviour of discretionary government spending in the USA.

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Notes

  1. The same result is obtained by Lane and Milesi-Ferretti (2002), Bénétrix and Lane (2009a) or Galstyan and Lane (2009a) for Ireland and de Castro and Fernández (2011) for Spain.

  2. Monacelli and Perotti (2010) make an interesting comparison of the effects of government spending shocks on private consumption and the real effective exchange rate across different theoretical frameworks.

  3. In all cases, the GDP deflator is employed so as to obtain the corresponding real values.

  4. The long-term interest rate is preferred to the short-term one because of its closer relationship with private consumption and investment decisions. However, this choice turned out to be immaterial to the results in that the inclusion of short-term rates in the VAR led to similar conclusions.

  5. More concretely, transfers include all expenditure items except public consumption, public investment and interest payments.

  6. This database is the same as that used in Burriel et al. (2010). Its main advantage is that it avoids the endogenous bias that arises if fiscal data interpolated on the basis of general macroeconomic indicators were used with macroeconomic variables to assess the impact of fiscal policies. While some authors might argue against using non-official, estimated time series, the use of quarterly data facilitates the identification of fiscal shocks under the Blanchard–Perotti approach, especially shocks to direct government spending. While it seems a sensible assumption that government spending decisions are predetermined within the quarter, it appears difficult to defend with annual data, thereby casting doubts on the estimated impulse responses in VARs, hence, our preference for relying on quarterly data.

  7. In order to assess the robustness of our results to different specifications and transformations, we tried several alternatives, including estimating with variables in per capita terms, allowing for four lags instead of two, introducing a deterministic time trend and substituting the long-term interest rate by a short-term one. These different alternatives showed broadly the same qualitative results.

  8. Focusing on the Euro Area does not prevent from relying on this identification scheme. This identification method, usually applied to single countries, is also valid in our case because fiscal shocks at the Euro Area level are ultimately fiscal shocks originated in one or several Member States at the same time. It is equivalent to identifying fiscal shocks in highly decentralised countries.

  9. In many cases, the income tax base includes interest income as well as dividends, which in general co-vary negatively with interest rates. Nevertheless, the full set of effects of interest rate innovations on the different tax categories is very complex to analyse, especially in the Euro Area, and, on the other hand, their contemporaneous effects are deemed to be very small.

  10. The absence of contemporaneous response to real exchange rate innovations is justified on the grounds of the home bias of public expenditure items, especially public consumption.

  11. We took this assumption from Perotti (2004), which Burriel et al. (2010) show that is immaterial for the EMU results. Were it not be for this assumption, our identification of government expenditure shocks would be equivalent to a simple Cholesky decomposition, with government spending ordered first.

  12. In the case of the USA, output and price elasticities amount to 1.94 and to 1.15, respectively. See Burriel et al. (2010) for further details.

  13. Edelberg et al. (1999),Fatás and Mihov (2001), Blanchard and Perotti (2002) or Perotti (2004) among others, choose 68 % confidence bandwidths to present their results.

  14. We performed Granger causality tests between our estimated government spending structural shocks and changes in the output gap with different lags. In no case was the null hypothesis that changes in the output gap do not Granger-cause spending shocks rejected. While we acknowledge that a more accurate way to assess whether anticipation effects matter would require to test whether professional forecasts Granger-cause the estimated VAR shocks, to the best of our knowledge no quarterly database exists for the Euro Area for the sample period considered, which makes such test impossible in practice.

  15. The cumulative multiplier at a given quarter is obtained as the ratio of the cumulative response of GDP and the cumulative response of government expenditure at that quarter.

  16. See Burriel et al. (2010). Specifically, focusing on Germany, Perotti (2004) gauges a short-term multiplier of around 0.5, whereas Heppke-Falk et al. (2010) obtain an impact multiplier one of 0.62. In turn, Baum and Koester (2011) get a cumulative output multiplier of 0.7 at the fourth quarter after the shock in their linear specification. de Castro (2006) and de Castro and Hernández de Cos (2008) estimate multipliers around 1.3 after 1 year for Spain, while Giordano et al. (2007) obtain much higher values, around 1.2 and 2.4 on impact and after four quarters, respectively, for Italy, although in this latter case multipliers only apply to a shock to purchases of goods and services.

  17. To identify the fiscal shocks, we need to compute the elasticities of fiscal variables to private consumption and investment. They are gauged by multiplying the GDP elasticities by the inverse of the output elasticities of private consumption and investment, respectively.

  18. The appreciation they obtain for Ireland is much lower than our estimates for the Euro Area. They find a real appreciation of 0.9 % on impact that increases in the subsequent 3 years to reach a 2.6 % appreciation in the third year.

  19. Monacelli and Perotti (2010) find that both components, traded and non-traded, depreciate in response to an increase in public spending.

  20. Ricci et al. (2008) and Lee et al. (2008) highlight the empirical role of government consumption as an important driver of medium-term real exchange rate movements for a large panel of countries.

  21. Galstyan and Lane (2009b) find that a shock of similar magnitude leads to a real appreciation of 2.14 in the Euro Area, well below the values reported here.

  22. Ravn et al. (2007) find that the presence of deep habits is able to lead to a countercyclical reaction of equilibrium markups. Thus, an increase in government spending would entail a generalised decline of markups in domestic markets with respect to foreign markets, thereby making the domestic economy relatively inexpensive. Hence, the real exchange rate would depreciate.

  23. See Galí et al. (2007).

  24. The depreciation following a public consumption shock is significant at the 68 % significance level but not at the 90 % significance level, as shown in Fig. 8.

  25. In none of both cases can the increase in home prices be taken as a good proxy for the increase in relative prices, given that both areas are fairly big and their shocks may have non-negligible effects on international prices.

  26. These countries are Australia, Canada Denmark, Japan, Korea, New Zealand, Norway, Sweden, Switzerland and the UK.

  27. We also tested whether the medium-run response of output to spending shocks could play a role by looking at the response of the REER to output shocks. Our VAR simulations showed opposite real exchange rate responses to an increase in GDP. In the case of the EMU, a spending shock leads to a GDP increase in the short-term and a non-significant response as of the fourth quarter and to a real exchange rate appreciation, while a shock to GDP leads to a real depreciation. By contrast, in the case of the USA, a spending shock also leads to a GDP increase in the short term accompanied by a real exchange rate depreciation. But similarly to the EMU case, the reaction of the real exchange rate to a GDP shock takes the opposite sign, leading to a real appreciation. Hence, the REER reacts differently in both economies to the same type of shocks, for which the dissimilar REER responses cannot be attributed to an opposite reaction to GDP shocks.

    Fig. 10
    figure 10

    Effects of government spending on the short-term nominal interest rate spreads

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  28. The change in the output gap as opposed to its level to assess the fiscal policy stance is currently preferred both in the European Commission and the IMF.

    Fig. 11
    figure 11

    Fiscal stance and short-term interest rate spreads

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  29. Even after the adoption of the euro, such safe haven role cannot be advocated either as the current sovereign debt crisis shows.

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Acknowledgments

We would like to thank Jacopo Cimadomo, Yiquiao Sun, the participants at the XIX Encuentro de Economía Pública (Santiago de Compostela), the 2012 CEUS Workshop (Vallendar), the XV Encuentro de Economía Aplicada (La Coruña) and two anonymous referees for very useful comments and discussions. The views expressed in this paper are those of the authors and do not necessarily reflect those of the Banco de España.

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  1. Banco de España and European Commission, Rue de la Loi 200, 1049, Brussels, Belgium

    Francisco de Castro

  2. Harvard University, Cambridge, MA, 02138, USA

    Daniel Garrote

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Correspondence to Francisco de Castro.

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de Castro, F., Garrote, D. The effects of fiscal shocks on the exchange rate in the EMU and differences with the USA. Empir Econ 49, 1341–1365 (2015). https://doi.org/10.1007/s00181-015-0925-z

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