Government expenditure and equilibrium real exchange rates

Government expenditures (financed by lump-sum taxes) influence real exchange rates potentially via a resource-withdrawal channel and a consumption-tilting channel. Recent theoretical and empirical studies have considered only the effects of government spending through the resource-withdrawal channel. We solve for the theoretical relationships among the real exchange rate, relative private consumption, relative government consumption, and tradables and nontradables production in a two-country general equilibrium model and then estimate the model’s structural equations. The results suggest that government expenditures influence real exchange rates approximately equally via the resource-withdrawal and consumption-tilting channels and that government and private consumption are complements in utility.