Fiscal expenditure and the exchange rate: A sticky -price, rational -expectations approach

This dissertation presents, solves, and estimates two sticky-price monetary models under rational expectations, to investigate the relationship between fiscal expenditure and the exchange rate. The first project extends the Driskill and Sheffrin (1981) (DS) model by adopting a detailed aggregate demand specification which includes a specific government purchases variable. We estimate the extended DS model for the DM/US$ exchange rate. As background to our extension, we also present an attempted replication, correction, and update of the DS results. Our replication and update are an improvement on the DS results. Most of our estimates are significant, correctly signed, and plausible; however, the restrictions imposed by the structural model and rational expectations are rejected. Our extended DS model estimation finds evidence for a negative, but insignificant, relationship between fiscal expenditure and the exchange rate. The second project adapts the Wickens (1985) model to a secular inflationary environment. We also modify the Wickens aggregate demand specification to capture dependence on real interest rate, and to specifically include a government purchases variable. In this model a permanent shock to the money supply could lead to either overshooting or undershooting of the exchange rate. However, our attempts at estimating the extended Wickens model for the Can$/US$ exchange rate, proved to be unsuccessful. An unconstrained version of the model finds some evidence for a link between fiscal expenditure and the exchange rate.