Fiscal Foresight, Forecast Revisions and the Effects of Government Spending in the Open Economy

• Authors: Luca Gambetti.
• BSE Working Paper: 110131 | September 15
• Keywords: fiscal policy , twin deficits , Mundell-Fleming , VARs , trade balance , forecast revisions , fiscal news , survey of professional forecasters
• JEL codes: C32, E32, E62
• fiscal policy
• twin deficits
• Mundell-Fleming
• VARs
• trade balance
• forecast revisions
• fiscal news
• survey of professional forecasters

This paper investigates the effects of government spending on the real exchange rate and the trade balance in the US using a new VAR identification procedure based on spending forecast revisions. I find that the real exchange rate appreciates and the trade balance deteriorates after a government spending shock, although the effects are quantitatively small. The findings broadly match the theoretical predictions of the standard Mundell-Fleming model and differ substantially from those existing in literature. Differences are attributable to the fact that, because of fiscal foresight, the government spending is non-fundamental for the variables typically used in open economy VARs. Here, on the contrary, the estimated shock is fundamental.