Fiscal policy and the real exchange rate: Some evidence from Spain

The factors influencing the real exchange rate are an important issue for a country’s price competitiveness, which is especially relevant to those countries belonging to a monetary union. In this paper, we analyse the relationship between fiscal policy and the real exchange rate for the case of Spain. In particular, we explore how changes in government spending, differentiating between consumption and investment, can affect the long-run evolution of the real exchange rate vis-à-vis the euro area. The distinction between two alternative definitions of the real exchange rate, based on consumption price indices and export prices, respectively, will also prove to be crucial for the results. Our results show that the composition of the fiscal consolidation measures matters as regards their effect on external competitiveness, but the definition of the real exchange rate also matters. A decrease in government consumption, relative to the euro area, would cause a depreciation of the CPI-based real exchange rate; unlike the case of the real exchange rate based on export prices, where it would result in an appreciation of the real exchange rate. A decrease in government investment, in turn, would lead to an appreciation of the real exchange rate in both cases. The estimated effect, however, is not quantitatively too high, particularly in the case of government investment. In addition, a worsening of the trade balance and a higher real per capita income relative to the euro area, would also lead to an appreciation of the real exchange rate, in the latter case just for the CPI-based real exchange rate. Accordingly, the way in which fiscal consolidation is achieved (i.e., whether based mainly on either government consumption or government investment cuts) and how the real exchange rate is defined, matters as regards their effects on the real exchange rate, and hence on price competitiveness.