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The theoretical literature has relied predominantly on the two-sector dependent open economy model; prominent contributions include Obstfeld (1989), van Wincoop (1993), Brock and Turnovsky (1994), Brock (1996), and Morshed and Turnovsky (2004). The empirical link between fiscal policy and real exchange rate fluctuations have been examined, among others, by Obstfeld (1993), Asea and Mendoza (1994), Chowdhury (2004), Kim and Roubini (2008), Galstyan and Lane (2009), Caporale et al. (2011) and Ravn et al. (2011).
See Engel (1993, 1999), Knetter (1993), Froot and Rogoff (1995), Taylor (1995), Edwards and Savastano (1999), and Cheung and Lai (2000) for some early contributions. For non-linearities in the adjustment path of the real exchange rate, see Taylor et al. (2001).
There is a voluminous literature on the role of public capital in affecting economic growth, starting with the work of Aschauer (1989) and Barro (1990). Important theoretical contributions include Glomm and Ravikumar (1994), Fisher and Turnovsky (1998), Rioja (2003), and Agenor and Aizenman (2007); see Agenor (2011) for a comprehensive review. Gramlich (1994) and Bom and Lithgart (2010) provide reviews of the corresponding empirical literature.
Morshed and Turnovsky (2004) provide several examples from post-World War II Western Europe to motivate the presence of intersectoral adjustment costs, such as the costly retro-fitting of war-time industries to produce consumer goods in the post-war era. Further, many developing countries adopt industrial policies that directly or indireclty subsidize private investment in their export sectors. These include the creation of Special Economic Zones (SEZ), subsidies for R&D, tax breaks, etc. We model the subsidy as an investment tax credit for transfering capital from the non-traded sector to the traded sector. The investment tax-credit has also been studied for the one-sector dependent economy model; see, for example, Sen and Turnovsky (1990).
A recent contribution by Cerra et al.(2010) also examines the effects of financing public investment by foreign aid. However, they model the flow of public investment as being relevant for production rather than the accumulated stock of public capital, along with a costless transfer of capital across sectors. The distinction between the stock and flow specifications turns out to be crucial for the predictions of the model. Chatterjee et al.(2003) and Chatterjee and Turnovsky (2007) also analyze the issue of infrastructure financing by foreign aid, but in the context of one-sector, one-good models of the open economy, which abstract away from issues related to the exchange rate.
Non-linearities in the adjustment path of the real exchange rate have been the subject of focus in models with transaction costs in international arbitrage; see Taylor et al. (2001) for a review of this literature. We also derive a non-linear adjustment path, albeit from a very different source (intersectoral adjustment costs and a gradually accumulating stock of public capital).
Note that h = 0 represents the standard Heckscher-Ohlin specification, where it is costless to transfer capital across sectors. On the other hand, when h → ∞, the model converges to the specific factors model, with capital being immobile across sectors.
The details of these results are available on request from the authors.
The details of these results are available on request from the authors.
Since this is a neoclassical model with a stationary steady-state, and the government is not an optimizing entity, we need a positive rate of depreciation for public capital to close the model. Otherwise, spending on public investment would have to arbitrarily jump to zero at the steady-state, which could not be justified with a passive government.
It is well known in the dependent open economy models that the dynamics depend critically on the sectoral capital intensities; for a detailed discussion see Turnovsky (1997).
Changes in welfare levels are computed by an equivalent variation in output across steady states, i.e., we determine the required change (in percentage terms) in the initial output level (and therefore in the output flow over the entire adjustment path), such that the agent is indifferent between the intial welfare level and that following the policy change.
Indeed, as we will see in section 4.3, when there are no intersectoral adjustment costs (h = 0), this non-monotonicity is absent from the path of the real exchange rate.
We will return to the issue of the short-run correlation between government spending and aggregate consumption in section 3.5.
Since these results are generated using a numerical solution, we are agnostic about the interpretation of the time “period,” which could be at monthy, quarterly, or annual frequency.