The Impact of Budget Deficits on Currency Value: A Comparison of Asian and European Countries

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ABSTRACT: This paper reexamines the relationship between budget deficits and exchange rates by applying Hakkio's (1996) model to seven Asian countries and eight Euro-currency countries over the years from 1951 to 2001. Applying the Time-Series Cross-Section Regression with the Seemingly Unrelated Regression approach to data from 15 countries, the results indicate that because of the indirect effect of the expected inflation rate, the risk premium, and the expected return rate, currency values are inversely related to budget deficits. However, the empirical results also present evidence supporting the Ricardian Equivalence Proposition that there is no direct effect of budget deficits on exchange rates.

INTRODUCTION

What is the impact of budget deficits on the value of currency? This question remains controversial among economists and monetary policymakers. The conventional macroeconomic theory suggests that when a government encounters a budget deficit, the likely financing method is to increase government borrowings, which puts upward pressure on real interest rates. High interest rates attract foreign capital inflows and consequently push up the currency value. In contrast, the Ricardian Equivalence Proposition argues that budget deficits and taxes are equivalent means of financing government spending. As a result, when government spending is constant, budget deficits have no real impact on an economy. Krugman (1979) proposes a Balance of Payment Crisis model indicating a negative relationship between the budget deficit and future exchange rates. Even though there are several studies (discussed in the next section, Budget Deficits and Exchange Rate) investigating this important subject, empirical results fail to consistently support any of the alternative hypotheses.

In an attempt to clarify this issue, Hakkio (1996) developed an empirical model that accommodates both positive and negative influences of budget deficits on exchange rates simultaneously. The conventional macroeconomic theory is reflected in the positive direct effect that larger budget deficits are associated with stronger currency values. At the same time, the budget deficits have a negative impact on currency values through three indirect effects - the expected inflation rate, the risk premium, and the expected rate of return. Because the direct and indirect effects are in force simultaneously, the net impact of budget deficits on exchange rates becomes an empirical issue, depending on which effect - the direct or the indirect - dominates.

The purpose of this paper is to extend previous studies by applying Hakkio's (1996) empirical model to a sample of selected economies in the Asia-Pacific basin and the Euro-currency area from 1951 to 2001. A common feature of the early studies is that they investigate the relationship between budget deficits and exchange rates based only on developed countries. The experience of the Asian countries is of interest not only because it was not considered in previous studies but also because of the growing importance of this region in international markets. The inclusion of selected participating countries of the Euro-currency area provides an opportunity for a comparison.

The rest of this paper proceeds as follows. Various theoretical models relating budget deficits to exchange rates are discussed in the next section. The third section describes the data and presents the methodological procedures. The empirical results are given in the fourth section, and the final section contains a concluding discussion of the results.

BUDGET DEFICITS AND EXCHANGE RATE

Three theories have predicted different impacts of budget deficit changes on the movements of exchange rates. The first two theories can be explained by using the loanable funds framework where interest rates are determined by the demand and supply of loanable funds. The conventional macroeconomic theory purports that an increase in budget deficit results in a rightward shift of the demand for loanable funds which, in turn, leads to an upward pressure on the interest rate and currency value. …