The effects of budget deficit reduction on the exchange rate

Public sector debt in the industrialized world has increased dramatically over the last 15 years. At the June 1996 Economic Summit in Lyon, France, leaders of the seven major industrialized democracies discussed the problems posed by large budget deficits and debt, as well as the potential benefits of regaining fiscal balance. The G-7 leaders agreed that while economic fundamentals in their countries are sound, investment growth, income growth, and job creation all depend on enacting credible fiscal consolidation programs and successful anti-inflationary policies.> While there is general agreement that cutting budget deficits and debt will lower interest rates, debate persists over the effects on a country's exchange rate. Unfortunately, the evidence on the relationship between budget deficits and the exchange rate does not readily resolve the debate. In the early 1980s, the rising U.S. budget deficit was associated with dollar appreciation, while in the 1990s rising deficits in Finland, Italy, and Sweden were associated with currency depreciation.> Hakkio analyzes the effects of budget deficit reduction on a country's exchange rate. First, he shows the evidence on the relationship between budget deficits and exchange rates is not clear-cut and explains why the theory that underlies the relationship is ambiguous. To sort out the ambiguity, he provides new empirical results indicating that deficit reduction through tax increases tends to weaken the exchange rate of countries with good records on inflation and debt, while deficit reduction through spending cuts tends to strengthen the exchange rate of countries with poor records on inflation and debt.