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The effects of budget deficit reduction on the exchange rate

Author

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  • Craig S. Hakkio

Abstract

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.

Suggested Citation

  • Craig S. Hakkio, 1996. "The effects of budget deficit reduction on the exchange rate," Economic Review, Federal Reserve Bank of Kansas City, vol. 81(Q III), pages 21-38.
  • Handle: RePEc:fip:fedker:y:1996:i:qiii:p:21-38:n:v.81no.3
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    Cited by:

    1. Lindblad, Hans & Sellin, Peter, 2003. "The Equilibrium Rate of Unemployment and the Real Exchange Rate: An Unobserved Components System Approach," Working Paper Series 152, Sveriges Riksbank (Central Bank of Sweden).
    2. Mylonidis, Nikolaos & Paleologou, Suzanna-Maria, 2011. "The real uncovered interest parity: The case of Canada and the USA," Journal of Policy Modeling, Elsevier, vol. 33(2), pages 255-267, March.
    3. Yaprak Gulcan & Mustafa Erhan Bilman, 2005. "The Effects of Budget Deficit Reduction on Exchange Rate: Evidence from Turkey," Discussion Paper Series 05/07, Dokuz Eyl├╝l University, Faculty of Business, Department of Economics, revised 12 Dec 2005.
    4. Olorunfemi Yasiru ALIMI & Olumuyiwa Ganiyu YINUSA & Ishola Rufus AKINTOYE & Olalekan Bashir AWORINDE, 2015. "Macroeconomic Effects of Fiscal Policy Changes in Nigeria," The Journal of Accounting and Management, Danubius University of Galati, issue 3, pages 85-94, December.

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    Keywords

    Budget deficits; Foreign exchange rates;

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