Fiscal Policy Shocks, Trade Balance, the Real Exchange Rate and Employment in a Small Open Economy

This paper employs a VAR model, to investigate the response of private and public employment, the trade balance and the real effective exchange rate to fiscal policy shocks for South Africa during the period 1994:1-2008:4. The results reveal that in the short run, a positive shock to government spending results in an increase in employment (public and private), an appreciation of the real effective exchange rate and deterioration in the trade balance; but it has no effect on output. Positive shocks to net taxes generate an increase in output, private employment and have no effect on public employment; it also leads to a depreciation of the real effective exchange rate and an improvement in the trade balance. Our results support the ‘twin-deficits' hypothesis, i.e., rising trade balances can be attributed to expansionary fiscal policy, however this is in sharp contrast to the ‘twin-divergence' hypothesis. Further, we note that classical effects are predominant in the South African economy