Composition of the Government Spending and Behaviour of the Real Exchange Rate in a Small Open Economy

The effects of government spending on a small open economy (SOE) have attracted little attention in the New-Keynesian SOE literature. One exception is Monacelli and Perotti (2007). In this paper we extend their work in several dimensions. First, we include both asset holder and non-asset holder households in the model. Second, we assume that the total government spending consists of spending on consumption goods and transfers to households. Modelling the government spending in this way enables us to analyse the responses of macroeconomic variables to different types of government spending shocks. Our results show that the effect of different types of government spending on the real exchange rate is different. Although, a rise in the government consumption spending leads to a depreciation, a rise in transfers to households leads to an appreciation.