Does the Fiscal Deficit Deteriorate the Real Exchange Rate? Evidence through an EGDE model for Argentina
DOI:
https://doi.org/10.35319/26r49g29Keywords:
General Equilibrium, Public spending, Tax Reduction, Real Exchange rateAbstract
According to standard theoretical frameworks, such as Real Cycles (RBC) models or Neo- Keynesian Theories, the real exchange rate should appreciate in response to an increase in public spending. However, the empirical literature finds mixed results. We offer an answer to this enigma by analyzing the impact of the fiscal deficit according to its composition on the real exchange rate. Using a dynamic and stochastic general equilibrium model with the government and the external sector, we quantify the differential impact on the real exchange rate generated by various sources of fiscal deficit: an increase in spending destined for public consumption, an increase in public investment and a reduction of taxes. We calibrate and simulate the model for Argentina and find that the fiscal deficit generated by tax reduction improves the real exchange rate while that generated by an increase in spending deteriorates the real exchange rate. This deterioration is more significant when spending is allocated to public consumption than when it is allocated to public investment. We argue that quantifying these different effects on the exchange rate within a dynamic stochastic general equilibrium framework is an essential political economy exercise for highly dollarized emerging economies that exhibit greater pass-through.
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