Government spending and real exchange rate dynamics
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A dynamic dependent-economy model is developed to investigate the role of government infrastructure spending and productivity in determining the path of the real exchange rate. The analysis, which employs extensive numerical simulations, shows that government expenditure directed towards infrastructure and productivity enhancement in the traded sector leads to real exchange rate appreciation, whereas if directed to the non-traded sector results in depreciation of the real exchange rate. Different sources of financing the government expenditure have also been considered, including lump-sum and distortionary taxation. Welfare analysis does not yield any linear relationship between real exchange rate and welfare gains; however growth-welfare tradeoff is justified for an increase in the traded sector expenditure.