Questioning the Puzzle: Fiscal Policy, Exchange Rate and Inflation

Abstract

The paper re-investigates the effects of government spending shocks on the real exchange rate and inflation. In contrast with some previous puzzling results, we find that an increase in government spending appreciates the real exchange rate and is inflationary; besides, it induces a trade balance deficit and a decrease in consumption. The discrepancy with the existing literature lies in the identification of fiscal shocks: embedding a narrative approach in a proxy-SVAR is what makes the difference. Empirical findings are then well explained by a standard estimated open real business cycle model

The macroeconomic effect of fiscal policy in South Africa: A narrative analysis

“…These include Hussain and Malik (2016), who investigate the asymmetric effects-tax increase vs decrease effect-of US tax changes using the Romer and Romer exogenous tax shocks in a non-linear model to compute impulse responses. Other papers that use narrative shocks in a proxySVAR model include Olea et al (2020), Ferrara et al (2020), and Mertens and Montiel Olea (2018. The benchmark results in Mertens and Ravn (2013) show that a cut in both personal and corporate income taxes increases both output and the respective tax bases.…”