Consumption, government spending, and the real exchange rate

Using panel structural VAR analysis and quarterly data from four industrialized countries, we document that an increase in government purchases raises output and private consumption, deteriorates the trade balance, and depreciates the real exchange rate. This pattern of comovement poses a puzzle for both neoclassical and Keynesian models. An explanation based on the deep-habit mechanism is proposed. An estimated two-country model with deep-habits is shown to replicate well the observed responses of output, consumption, and the trade balance, and the initial response of the real exchange rate to an estimated government spending shock.