Two current policy problems for Ireland are to tackle the loss of external competitiveness and to determine the appropriate level and composition of government spending. These issues are linked, since government spending affects the real exchange rate for Ireland, through its impact on the relative price of nontraded goods in terms of traded goods.
In a new paper “Fiscal Policy and International Competitiveness: Evidence from Ireland” (joint with my TCD colleague Vahagn Galstyan), we show that the long-run behaviour of the real exchange rate and the relative price of nontradables is increasing in the long-run level of government consumption but decreasing in the long-run level of government investment.
The intuition is that government consumption tends to drive up economy-wide wages and nontraded prices (since the public sector competes for scarce labour and non-traded inputs), while government investment in the long run improves productivity (especially in the non-traded sector) which is associated with a reduction in the relative price level.
The appropriate levels of government consumption and government investment depend on a range of socio-political factors, but these results are worth noting in any debate about the connections between fiscal policy and external competitiveness.