Analyzing and investigating the response of inflation and exchange rate to financial policy shocks

Objective: Since the Great Recession of 2007-2008, the debate on the role of fiscal policy and government spending shocks has been taken into consideration, and governments' fiscal measures have been restarted in order to control crises to act as a policy tool in the economy of countries. The renewed interest in the role of fiscal policy has stimulated considerable scholarly research into its effects. However, despite the importance of this question, there is still no consensus on how inflation and the real exchange rate react to government spending shocks. Based on standard theoretical frameworks, the real business cycle and the old and new Keynesian theories, the real exchange rate increases in response to the increase in government spending and inflation increases accordingly. In other words, government spending shocks are inflationary and increase the real exchange rate; this factor leads to a worsening of the trade balance and reduces private consumption. These dynamics are in line with standard theoretical predictions. While on the other hand, the results of some studies show that these shocks reduce inflation. In this study, the response of inflation and exchange rate to fiscal policy shocks has been investigated using the SVAR approach. Contrary to conventional views Protti (2005) mixed evidence of inflation response in five OECD countries including the United States shows that there is little evidence to support the popular view that government spending shocks are inflationary. Several prominent studies of fiscal policy do not consider the price response at all, and most authors who find evidence of a reduced or negative price response make no attempt to provide a structural explanation for it. It is difficult to reconcile empirical findings with traditional accounts of the fiscal policy transmission mechanism. From a theoretical point of view, the uniform or negative response of prices constitutes a puzzle for the new Keynesian model. To provide a structural interpretation of the results, a version of the New Keynesian model is proposed that includes the time-varying adoption of new technology in the production process, as shown in the recent work of Anzo et al (2019) and Bianchi et al. (2019). The private sector decides how much to use the level of technology available. In response to increased government spending, the private sector finds it optimal to increase technology utilization rates in order to meet increased aggregate demand, despite the costs associated with higher utilization rates. Increased use of technology increases measured productivity, consistent with the empirical evidence presented. Provided that this mechanism is strong enough, that is, increased use of technology should dominate the upward pressure on marginal costs from higher wages and lead to lower marginal costs in equilibrium. Lower marginal costs pave the way for the private sector to lower prices, thereby reducing inflation. In response to inflation, the central bank reduces the nominal interest rate and leads to a decrease in the real interest rate. This, in turn, facilitates increased consumption. In the New Keynesian model, a negative corollary between inflation and private consumption is usually implied under a government spending shock, but the sign is opposite to that suggested by the data: inflation rises and consumption falls after a positive government spending shock. In the model of this article, an analytical description of the parameters required by the model to create findings is presented, which will have a wide range of parameters. The model is then augmented with several real characteristics, including capital formation, real wages, and consumption, and key parameters are estimated using inflation-response matching to government spending shocks. Also, the use of the technology variable is an essential feature for the current model in terms of quality as well as quantity and the empirical effects of shocks to government spending. While it is commonly believed that government spending policy - at least in the short term - mainly affects the demand side of the economy (Blanchard and Perotti, 2002), the model in this paper also suggests significant effects on the supply side. The endogenous response of productivity (TFP) increases the government spending coefficient without causing inflationary pressure in the economy. This makes government spending more attractive as a policy tool. According to these issues, in this article, we will examine the response of inflation and exchange rate to fiscal policy shocks using structural vector auto regression (SVAR) models, which are known as impulse models and can measure the effects of impulse and uncertainty and fluctuations created by each of the indicators. Economic activities are calculated and paid.



Method: The purpose of this study is to analyze and investigate the response of inflation and exchange rate to fiscal policy shocks for the years 1991-2021. For this purpose, using the structural vector auto regression model (SVAR), which are known as impulse models; the response of inflation and exchange rate to the shocks of government construction expenditure, production, private consumption, trade balance and productivity of total factors were investigated.



Results: According to the results, the response of the impulse coefficient of government construction expenditure to inflation and real exchange rate is positive and equal to 0.05 and 5.48. Also, the response of the coefficient of private consumption impulses to the real exchange rate is equal to -5.66. The coefficient of impulses of the trade balance in the inflation equation is also negative and equal to -0.92. In other words, an increase in government spending causes an increase in the exchange rate, a decrease in the trade balance, and a decrease in consumption.



Conclusion: The real exchange rate increases in response to the increase in government spending and inflation increases accordingly. According to the results for Iran's economy, government expenditure shocks are inflationary and increase the real exchange rate; these factors lead to a worsening of the trade balance and reduce private consumption. These dynamics are consistent with standard theoretical predictions, the real business cycle, and old and new Keynesian theories.