Government Spending, GDP and Exchange Rate in Zero Lower Bound: Measuring Causality at Multiple Horizons

Abstract

This paper assesses the Granger causality between government spending and gross domestic product (GDP) in the United States at multiple horizons. This paper also analyses the role the real exchange rate plays in the causality measure during the zero lower bound (ZLB) period. Many researchers using theoretical models built in a closed economy suggest that the elasticity between government spending and GDP is very large, when the nominal interest rate is binding. Other researchers, also using theoretical models generally built in an open economy, suggest that the elasticity in the ZLB period is not large. The same conflicting results are reported in the empirical literature mostly using vector auto regressives (VARs), with different restrictions. In this paper, we use a different approach to measure the link between the two variables. The new approach has the advantage of not relying on any restrictions, as is the case with VARs when dealing with causalities. Moreover, our approach is not related to the way the model is built, as is the case with dynamic stochastic general equilibrium (DSGE) types of models. In this paper, we use a Granger causality measure to compare the causality for normal periods with the causality for the ZLB period. We emphasize the role played by the real exchange rate. Our empirical results provide evidence that the causality measures between government spending and GDP are larger and persistent in the ZLB period, but only if the exchange rate is not taken into account. When the exchange rate is taken into account, our measure of causality becomes very small and non-persistent.

Revisiting the AA-DD Model in Zero Lower Bound

“…Unlike the current AA-DD model, our new AA-DD model is consistent with recent results from the literature that highlights the negative effect of the exchange rate on the government spending multiplier in ZLB (see for example (Mao Takongmo, 2017;Mao Takongmo & Lebihan, 2021)).…”

“…Mao Takongmo & Lebihan (2021) use data to analyze the role the real exchange rate plays in the Granger causality measure between government spending and gross domestic product (GDP) in the United States during the zero lower bound (ZLB) period. Mao Takongmo & Lebihan (2021) show that causality measures between government spending and GDP are larger and persistent in the ZLB period, but only if the exchange rate is not taken into account.…”

Analysis of exchange rates in the economic uncertainty era

“…A study by Mao Takongmo & Lebihan (2021) explored the correlation between GDP and Rupiah currency spanning from 2014 to 2020 utilizing multiple linear regression and quantitative analysis methods. The study concluded that GDP does not singularly influence the exchange rate.…”