Anticipated Budget Deficits and the Real Exchange Rate

This paper explores the relationship between government budget deficits and the real exchange rate. While the conventional view is that a deficit generates real exchange rate appreciation, the experience of many small economies appears to contradict this belief. In this model, the impact of an announced future deficit depends on the elasticity of intertemporal substitution. If it is high, an announced deficit gives rise to immediate real exchange rate appreciation, a deterioration in the trade balance, and a fall in welfare of current generations. When a low elasticity of intertemporal substitution exists, however, an announced deficit may generate a real depreciation, with the opposite impact on the trade balance and welfare. Moreover, in this case, the announcement of a future deficit will increase the intertemporal volatility of the real exchange rate but leave its average value unaffected.