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Public sector debt in the industrialized world has increased dramatically over the last 15 years. From 1980 to 1994, government debt rose from 37 percent of GDP to 63 percent in the United States, and from 41 percent to 70 percent in the major industrialized countries. 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. At the August 1995 Jackson Hole symposium on "Budget Deficits and Debt: Issues and Options" sponsored by the Federal Reserve Bank of Kansas City, some participants argued the exchange rate would be strengthened by deficit reduction, while others argued it would be weakened. 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.
This article analyzes the effects of budget deficit reduction on a country's exchange rate. The first section 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, the second section 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.
DEFICIT REDUCTION AND EXCHANGE RATES: EVIDENCE AND THEORY
The relationship between deficit reduction and exchange rates has caused a debate among the world's most respected monetary policymakers and analysts. Federal Reserve Board Chairman Greenspan and Governor Thiessen of the Bank of Canada have argued that deficit...