Fiscal Policy, the Trade Balance, and the Real Exchange Rate: Implications for International Risk Sharing

We employ structural VAR techniques to estimate, for a series of OECD countries, the eects of government spending shocks on the real exchange rate, the trade balance and their comovements with GDP and private consumption. First, we …nd that in all coun- tries a rise in government spending induces a real exchange rate depreciation and a trade balance de…cit. In the US, however, the eect on the trade balance is small. We show how recent empirical evidence that points to a decline in the trade de…cit after a budget de…cit shock can be traced to an alternative (and, in our view, questionable) method to recover the …scal shocks. Second, in all countries private consumption rises in response to a government spending shock, and therefore comoves positively with the real exchange rate. This result is in stark contrast to virtually all models with complete asset markets and separable utility, including an open economy New Keynesian model with price stick- iness and capital accumulation. But an extension of the model to include non-separable preferences in consumption and leisure is able to replicate (at least qualitatively) the re- sponses of consumption and the real exchange rate that we …nd in the data. Furthermore, if the elasticity of substitution between domestic and imported goods is su¢ ciently small, the model is also successful in delivering the right comovement between the real exchange rate and the trade balance.