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Second Quarter 2024, 
Vol. 106, No. 2
Posted 2024-04-15

Accounting for the Effects of Fiscal Policy Shocks on Exchange Rates through Markup Dynamics

by Hyungsuk Lee and Junsang Lee


This study investigates how fiscal policy shocks affect the external sector through markup dynamics in advanced and developing economies. We focus on the role of markup dynamics as a channel through which fiscal policy has a distinct effect on real exchange rates. Using panel data from 32 countries, we employ a local projection to evaluate the impact of expansionary fiscal policy shocks on real exchange rates, markups, and current accounts. Our empirical findings show distinct responses to the shocks among advanced and developing countries regarding the real exchange rate, due to different markup dynamics. Expansionary fiscal measures result in an appreciation of the real exchange rate and an increase in markup for developing countries, whereas advanced economies experience a decrease in markup and a depreciation of the real exchange rate. Markup dynamics vary between advanced and developing economies due to differences in firms' entry and exit conditions in their institutions. In advanced economies, expansionary fiscal policy shocks promote competition and new firm entry, resulting in a reduced markup. On the other hand, unfavorable conditions in developing countries maintain or increase existing firms' market power. Our research highlights the heterogeneous effects of fiscal policy shocks on the external sector, emphasizing the need for policymakers to consider institutional and entry conditions while designing and implementing fiscal policies.

Hyungsuk Lee is a research fellow at the Hyundai Research Institute, Seoul, Korea. Junsang Lee, the corresponding author, is a professor at the School of Economics, Sungkyunkwan University, Seoul, Korea.


In recent decades, fiscal policy has emerged as a pivotal instrument for governments worldwide to stimulate economic growth and maintain stability. Fiscal policy entails the strategic deployment of government expenditure and taxation to steer the economy toward desired objectives, such as achieving full employment, controlling inflation, and promoting equitable income distribution. However, the effectiveness of fiscal policy is not uniform among all countries and is influenced by factors such as institutional architecture, market entry conditions, and the level of competition among firms. For example, the institutional environment may shape the responsiveness of fiscal policy through factors such as governance quality, legal and regulatory frameworks, and fiscal decentralization (Acemoglu, Johnson, and Robinson, 2001; Rodrik, 2008; Avell├ín, Galindo, and Leon-Diaz, 2020). Market entry conditions and level of competition among firms can also influence how fiscal policy permeates through the economy (Djankov et. al., 2002; Blanchard and Giavazzi, 2003; Aghion et al., 2005; Klapper, Leaven, and Rajan, 2006).

We concentrate on examining the role of markup dynamics in assessing the impact of fiscal policy shocks on the external sector, such as the real exchange rate and current accounts, among countries based on their level of development. Previous studies have suggested that markup variability can explain real exchange rate dynamics. Specifically, a rise in markup results in an appreciation of the real exchange rate, whereas a decrease in markup leads to a depreciation of the real exchange rate (Bouakez, 2005; Gust, Leduc, and Vigfusson, 2010; Ravn, Schmitt-Grohe, and Uribe, 2012). Our study explores whether markup dynamics can be a key determinant in how expansionary fiscal policy shocks affect real exchange rate dynamics. Our study suggests that if aggregate markups increase (decrease) in response to a government expenditure shock, the real exchange rate will appreciate (depreciate).

The response of markup dynamics to expansionary fiscal policy shocks differs among advanced economies and developing countries, primarily due to differences in institutional and firm entry conditions. Advanced economies typically provide a more favorable and conducive business environment with lower regulatory burdens and greater competition, leading to firm growth and market entry. Expansionary fiscal policy shocks in these economies tend to intensify competition and lead to a decline in markup. On the other hand, in developing countries, firms with market power may exploit increased demand during economic booms, resulting in an increase in markup due to a lack of competition. The relationship between fiscal policy shocks and markup dynamics depends on the underlying institutional and entry conditions in both economies. To substantiate the claim that favorable institutional and entry conditions foster a competitive business environment, we use data from the World Bank's Global Entrepreneurship and Development Index (GEDI). This index reflects how such favorable conditions enable new firms to enter the market and compete with existing firms, which tends to result in a decline in overall markup. In contrast, elevated entry barriers and unfavorable institutional conditions hinder new firms from entering the market, thereby allowing established firms to preserve or even augment their market power.

Our study provides a comprehensive understanding of the intricate and diverse effects of fiscal policy shocks on the external aspects of both advanced countries and developing economies. Our empirical results highlight the fundamental importance attributed to institutional and entry conditions in shaping real exchange rate dynamics, emphasizing the importance of considering these factors in policy design and implementation. Our research contributes significantly to the previous literature on fiscal policy implications for the external sector, examining the varied changes in the real exchange rate and markup and identifying potential mechanisms driving these responses.

We propose a novel explanation for the distinct real exchange rate dynamics observed between advanced and developing nations by investigating the effect of markup dynamics on fiscal policy shocks. Miyamoto, Nguyen, and Sheremirov (2019) highlight the discrepancy between the theoretical results of canonical international business cycle models and the empirical evidence regarding real exchange rate dynamics. While these models can account for the appreciation of the real exchange rate in less developed nations, they inaccurately predict real exchange rate appreciation for advanced countries when empirical data indicate depreciation. Our empirical analysis suggests that the divergent markup dynamics in advanced and developing economies contribute significantly to the differing real exchange rate dynamics between these groups. In particular, we emphasize the pivotal role of institutional and entry conditions in shaping the behavior of real exchange rates to expansionary fiscal policy shocks, underscoring the need to consider these elements during the formulation and execution of policy initiatives.

In addition, we use variations in military or defense spending as instrumental variables (IVs) to identify government expenditure shocks, following Hall (2009), Barro and Redlick (2011), Ramey (2011), and Miyamoto, Nguyen, and Sheremirov (2019). The underlying assumption is that military spending is not correlated with the overall economic state, such as the business cycle, monetary policy, or private sector financial conditions. By instrumenting fiscal policy shocks with defense expenditure, we attribute government spending shocks to unanticipated variations in military spending, which neither output, fiscal policy, nor other control variables can predict.

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