Academic journal article
By Nakibullah, Ashraf
Economic Inquiry , Vol. 31, No. 2
The total United States budget deficit was roughly zero at the beginning of 1981. After some ups and downs, the deficit reached $140 billion in early 1985 and remained high compared to deficit levels experienced in peacetime years prior to 1981. During the period 1981-1985, the U.S. dollar appreciated sharply relative to foreign currencies in both nominal and real terms. The current account of the U.S. balance of payments moved from a surplus of $6.0 billion in 1981 into a series of large, recurrent deficits reaching an annual rate of $120 billion by mid-1985.
The simultaneous occurrence of these events suggests that budget deficits cause a country's currency to appreciate which in turn reduces the country's "international competitiveness." Stories are reported in the popular financial press and conventional wisdom is used to link these events. Using the identities of national income accounts, it is shown that budget deficits must crowd out domestic spending by raising the domestic saving-investment gap. In addition, the deficits can be financed by the rest of the world through the generation of a deficit in the current account of the balance of payments. Typically it is argued that the rise in the rate of interest and real appreciation of the dollar are necessary in order to bring about the saving-investment gap and the current account deficit needed to finance the large U.S. budget deficits.
This paper attempts to provide an alternative structural explanation of these comovements in exchange rates and government budget deficits. My model expands on previous work to include fiscal policy considerations in a stochastic setup. It shows that within a simple two-country cash-in-advance constraint model it is possible to have a positive correlation between increases in the budget deficit and exchange rate appreciation. Additionally, it is possible to have a negative correlation between exchange rate appreciation and a reduction in domestic traded goods production. The implication, then, is that the usual "twin deficits" argument about the linkages between budget deficits, exchange rates and trade deficits is only one of a number of possible explanations of the correlations that appear in the data of the 1980s.
The model I have used in this paper is (as far as I know) the first international general-equilibrium-monetary asset-pricing model with endogenous budget deficits. Most of the explanations that relate exchange rates and the federal government's budget deficit or the trade deficit are based on a particular disequilibrium theory of exchange rates. The model of this paper, however, is based on an equilibrium model of exchange rates. It is based on simple economic principles. It uses the national accounts definition of the government's nominal budget deficit as an increase in the dollar value of the government's holdings of money and bonds. A change in the domestic productivity of traded goods and the money supply yields a change in both the nominal price of bonds and the government budget deficit. A change in the supply of domestically produced traded goods also yields changes in their relative price (the real exchange rate). Repeated disturbances to the supply of traded goods and the money supply create a correlation between budget deficits and real exchange rates.
Recently Branson and Love |1988~ and Ceglowski |1989~, among others, blame the real exchange rate as the primary cause of U.S. industries' weak performance in the 1980s. It is important to realize the real exchange rate itself is an endogenous variable. Its behavior, as I will show, is a result of underlying economic changes. Hence, it is incorrect to blame decreased U.S. competitiveness on the real exchange rate. Moreover, most popular models which presume a relationship between budget deficits and real exchange rates attribute no role to the monetary sector. This paper demonstrates the importance of bringing both monetary and real sectors into the model in order to analyze such relationships. …