Fiscal Policy
Deficits and the Exchange Rate

The sizeable budget deficits of the United States government have been blamed for a variety of ills in the world financial system. Their precise effects have concerned both economic theorists and applied researchers and were discussed at length during the recent CEPR/NBER policy coordination conference.

Research Fellow Sweder van Wijnbergen explores, in CEPR Discussion Paper No. 21, the implications of a particular form of budget deficit. Working with a two-country model, he analyses the effect of a deficit in the 'home' country, brought about by a cut in commodity taxes. He assumes that capital markets are perfect and that the private sector has the benefit of perfect foresight in its intertemporal optimization. The change in the tax structure caused by the commodity tax cut will shift home expenditure towards the present. The home country's increased government deficit will therefore be associated with a larger current account deficit. World real interest rates must rise, to choke off the tendency to extra current spending worldwide.

What is the effect on the real exchange rate of this budget deficit? This depends on spending patterns at home relative to those abroad. If home consumers spend proportionally more on home goods than foreigners spend on home goods, then the increased deficit will lead to a real appreciation of the exchange rate in the country where the deficit has gone up. If spending patterns are symmetric, deficit spending will have no effect on the exchange rate. In practice, transport costs make the the former condition more likely. This lends support to the emerging consensus on the causal link between high budget deficits and high world real interest rates, appreciation of the real exchange rate, and increased current account deficits in the country running the budget deficit.

Van Wijnbergen also discusses the recent proposal for an interest equalization tax, which under present circumstances amounts to a tax on foreign borrowing by the United States. He argues that it is a 'beggar-thy-neighbour' policy resembling optimal tariff arguments from trade theory. Although it would work, in the sense of bringing the real exchange rate down, it may make both countries worse off in the process. It may be better to reduce the deficit, he argues, instead of sustaining the deficits and compounding the welfare losses by the equalization tax.


On Fiscal Deficits, the Real Exchange Rate and the World Rate of Interest
Sweder van Wijnbergen

Discussion Paper no. 21, June 1984 (IM/IT)