Understanding the Dynamic Effects of Government Spending on Foreign Trade

In order to understand the dynamic effects of government spending on foreign trade the present paper proceeds in two steps. First, using U.S. time series data for the post-Bretton-Woods period, the dynamic effects of government spending are investigated within a structural Vector Autoregression framework: the nominal exchange rate is found to depreciate, the terms of trade to appreciate and the trade balance to increase significantly after a temporary increase in government spending. In a second step, a New-Keynesian general equilibrium model is used to rationalize these effects. Two findings emerge: i) a low elasticity of substitution between home and foreign goods is necessary for the trade balance to improve after an increase in public spending. ii) an accommodating monetary policy is found to dampen the effects of government spending on foreign trade.