GOVERNMENT PURCHASES AND RELATIVE PRICES IN A 2-COUNTRY WORLD

The effects of government expenditures on the terms of trade, the real exchange rate, and the real interest rate are examined in a three-goo ds (importables, exportables, and nontradables), two-country, inter-te mporal, optimizing model. Temporary spending increases on tradable or nontradable goods may raise or lower the world return on international ly traded bonds and may improve or worsen the current account of the c ountry undertaking the fiscal expansion. The paper's results also shed light on the theoretical determinants of the co-movement between the terms of trade and the real exchange rate in response to changes in fi scal policies.