This paper examines a puzzle related to the impact on the real exchange rate of government spending on physical capital. Referring to the results of most empirical studies, an increase in expenditures on public capital leads to an appreciation of the real exchange rate. This result contradicts the findings of existing theoretical papers. In the latter studies, the real exchange rate depreciates following a rise in public capital spending. We develop a theoretical model to sort out the puzzle. We show that the real exchange rate can move in both directions following an increase in public spending on capital. In contrast to some existing theoretical studies, we depart from an exclusive emphasis on the impact of government spending on capital on the demand side of the economy. We also consider the impact of public capital on the supply side of the economy. We develop a small-open New Keynesian DSGE model with traded and non-traded goods, real and nominal rigidities, and productive government spending. The latter affects the productivity of private factors besides impacting the demand side of the economy. We explore the role played by the output elasticity of public capital on the dynamics of the real exchange rate. By being able to focus on both the supply and demand sides of government spending on public capital, we can shed light on its net effects on the dynamic response of the real exchange rate. Specifically, we assess the responses of the real exchange rate and other real variables following innovations in government spending on public capital. We run some sensitivity analyses on the magnitude of the output elasticity of public capital and of other key parameters of the model.
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