Budget Deficit, External Official Borrowing, and Sterilized Intervention Policy in Foreign Exchange Markets
I study the effect of a temporary budget deficit, which is financed in the international capital market, on the exchange rate. First, I show that the exchange rate depreciates both in the short and in the long run if the government finances the deficit by selling debt denominated in foreign currencies to nonresidents. Secondly, I show that the government can prevent an immediate depreciation of the exchange rate by adopting a policy of sterilized intervention; however, the achievement of this short-run exchange rate target implies a long-run depreciation of the real exchange rate.
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