The effect of budget deficits on exchange rates: Evidence from five industrialized countries

J ECO BUSN 1994:46:397-408

397

The Effect of Budget Deficits on Exchange Rates: Evidence From Five Industrialized Countries Stacie E. Beck

Evidence of insignificant correlations between budget deficits and interest rates has been interpreted as support for the Ricardian equivalence proposition. Alternatively, international capital flows could transfer deficits' effects from interest rates to exchange rates. This paper investigates these alternative hypotheses by testing the significance of budget deficit and government spending changes on exchange rates in five industrialized countries: U.S., Germany, Japan, U.K., and Canada. The estimation uses forecast data for the fiscal policy expectations variables. The evidence is mixed: it supports the open economy hypothesis in three countries, but the Ricardian equivalence proposition in one country--Japan.

According to conventional macroeconomic theory, large government budget deficits crowd out real investment by raising interest rates. The Ricardian equivalence proposition states that large deficits have no real economic effects because households increase savings to offset anticipated future tax liabilities implicit in deficits. Consequently, interest rates remain unchanged and budget deficits have no adverse macroeconomic consequences [Barro, (1974)]. Although the strong assumptions necessary for the Ricardian equivalence proposition may not actually hold, some argue the proposition is a reasonable approximation to reality [e.g., Seater (1993)]. Important empirical evidence supporting the proposition is the insignificant correlation between budget deficits and interest rates found by Plosser (1982), Evans (1987a, b), and Darrat (1990). 1 Is there another explanation for this evidence? If capital is mobile so that interest rate parity holds, financial market participants anticipate that higher interest rates will attract capital inflows, so they bid up the price of domestic currency immediately. In this case, interest rates do not Department of Economics, University of Delaware, Newark, Delaware (SEB). Address reprint requests to Professor Stacie E. Beck, Department of Economics, University of Delaware, Newark, Delaware 19716-2720. ~Other authors [Hoelseher (1986), Thomas and Abderrezak (1988), and Wachtei and Young (1987)] found some evidence that long term interest rates and deficits are positively correlated. Journal of Economics and Business © 1994 Temple University

0148-6195/94/$07.00

398

S.E. Beck change and budget deficit effects are reflected in exchange rates instead. Exports, rather than real investment, will be crowded out [see Turnovsky (1986) or Dornbusch (1976)]. The major study on this alternative hypothesis was done by Evans (1986). 2 He found that increases in U.S. budget deficits caused dollar depreciation rather than dollar appreciation, so he concluded that his evidence supports the Ricardian equivalence proposition. However, there have been two criticisms of this study. Feldstein (1986) hypothesized that changes in expected future deficits, rather than the unanticipated changes in the current deficit tested by Evans, are more important to market participants. Using his deficit variable, Feldstein found that increased U.S. budget deficits caused dollar appreciation vis-a-vis the West German mark, as conventional open macroeconomic theory predicts. Hence, Feldstein concluded Evans' specification was incorrect. A second criticism is Evans' use of the vector autoregression (VAR) technique to create the expected variables, a procedure that assumes market participants rely only on past information to predict future government policy, but do not incorporate currently available information [see Hodrick (1989), p. 266 for a discussion]. Hodrick failed to obtain Evans' results in a study using the same techniques with more recent data, and concluded that "the VAR methodology is very suspect and cannot be used to interpret causal influences on exchange rates and capital flows" [Hodrick (1989), p. 270]. This study tests the Ricardian equivalence proposition that deficits do not affect exchange rates against the alternative: that capital mobility transfers budget deficit effects to exchange rates. Important objectives are to avoid the aforementioned problems with Evans' study and also to extend the study to include other countries. Both Evans' and Feldstein's specifications are tested, and if Ricardian equivalence holds, the deficit variable should be insignificant in both cases. Alternative data for the expectations variables are used that avoid the drawbacks of the VAR technique. These are the forecasts made by the Organization of Economic Cooperation and Development (OECD). 3 The advantage of forecast data is that they capture anticipated policy changes, whereas data generated by V A R techniques rely only on past behavior. This is more appropriate for policy variables that are determined largely exogenously, such as government spending (net of transfers) and the cyclically adjusted (i.e., structural) deficit. Only a short forecast series, from 1980 to 1989, is available for each country, so data from the five countries were pooled to obtain an adequate sample size. From this panel data, results for all five countries were obtained. Regressions include both domestic and foreign variables. This contrasts with Evans, Feldstein, and Hodrick, whose studies are only for the U.S. and use only domestic data. 4 Data include the U.S., Japan, West Germany, U.K., and Canada, because capital

ZThere is also Feldstein's (1986) study, which is discussed later in this paper, and Hodrick's (1989) update of Evans' study. Beck (1993) researched U.S. deficit announcement effects on dollar exchange rates. Studies on correlations between budget ad trade deficits also have been done [see Seater (1993), p. 177 for a discussion].However,the more dire.el approach taken here is to test for the budget deficit effects on exchange rates that lead to trade deficits. 3In his study, Feldstein used the forecasts of Data Resources, Inc. for expected U.S. deficits. 4Evans' (198710)study on data from six countries focussed on interest rates, not exchange rates.

Effects of Budget Deficits on Exchange Rates

399

mobility is most likely to hold for these countries: France and Italy were not included because their currencies are linked to the mark and are not independent time series. I. S p e c i f i c a t i o n s

and Hypotheses

Specifications similar to both Evans and Feldstein were both estimated because the deficit variable should be insignificant in either case if Ricardian equivalence holds. The two specifications are written here in terms of the forecasted variables provided by OECD. This also permits comparison of the major differences between them. Evans [(1986), p. 231] specified the following estimation model:

s,t-s~=ami[(m-P)t-(m-P)~] +(%i + I)[Pt-Pt] + Otbi[b t -- b:] + Otgi[g t - gt]

(1)

where sit is the logarithm of the price of currency i in terms of the domestic currency, ( m - P ) t is the logarithm of the real money supply, Pt is the logarithm of the price level, b t is the logarithm of the budget surplus/deficit as a percent of G N P , gt is the logarithm of government spending as a percent of GNP, x T = E(xtllt-1), and I t_ 1 is information from periods up to t. The following relationships were employed to replace (m - p ) and p: M t = (1 +

iAt)Mt_l,

Pt = (1 +

"?l't)Pt_l,

where M t is the nominal money stock level, Pt is the price level,/z t is the nominal money stock growth rate, and ~rt is the inflation rate. Therefore, m t ~ tzt + m t _ 1 , e

mt=

e

~t +mr-l,

P t "~ 7I't + P t - 1 ,

P t = *rt + Pt- 1,

and (m, - m D = ( ~ t -

(pt -p:)

=

~),

(~r, - ~':).

5Beck (1993) showed that capital mobility is a good assumption for the U.S. although it is a large and closed economy compared to the other four countries.

400

S.E. Beck These substitutions and some rearranging allow (1) to be written as sit - Siet = ao + al( l.*t - I.X~') + a2(7"rt -

rrt e) + a 3 ( b t - b [ ) + a 4 ( g t - g [ )

(2)

OECD projections exist for inflation, budget surpluses/deficits, and government spending variables, but independent money growth rate projections were not made. Instead, the agency relied on announed money targets. These targets also were used here for /zt; however, a drawback is ihat targeted variables differ between countries, whereas it is desirable to have commonly defined variables in pooled data. Two other approaches were investigated, both using a money variable commonly defined across countries. One assumed that the expected future money growth rate depends only on the current growth rate; hence, /.¢,' = / z t_ l. The second assumed that /x~ is based on current information in addition to the current growth rate. 6 The results are similar for all three procedures, so only those under the assumption /ze =/.t t_ l are reported, to facilitate comparison with the second (Feldstein) specification below. Several proxies may be used for the expected future spot exchange rate sit. One is the current spot rate sit_ 1, another is the current forward rate f / t - 1 , and the third is generated with an economic model. Meese and Rogoff (1983) found that current exchange rates incorporate anticipated future exchange rate movements and economic models cannot forecast better. Their results indicate that sit_ 1 or f/e- 1 provide the best proxies; hence, these were substituted for s[,. Only those for s i t - 1 = sit are reported here because the results are very similar for each] Meese and Rogoff's conclusions also imply that exchange rates are random walks. Although there is recent evidence that exchange rates are not truly random walks, the random walk forecast has not been beaten on a consistent basis [see, e.g., Diebold and Nason (1990), Chinn (1991); and Engel and Hamilton (1990)]. However, these studies used quarterly data, whereas annual data are used here. Some authors suggested that exchange rates exhibit deterministic trends as well as stochastic trends over long periods, possibly driven by economic fundamentals [e.g., Frankel (1985)]. To test whether they exist here, trend terms were added to Eq. (2). Only those for U.K. and Canada were significant, and the signs and significance of the other coefficients were similar to those reported. For completeness, trend terms also were added to Eq. (4), but none was significant and the other coefficients' signs and significance were unaffected. These results suggest that either trends are generally not important or that the explanatory variables in Eqs. (2) and (4) capture the economic factors that drive these trends. Feldstein regressed the expected future deficit, expected inflation, the monetary base growth rate, and two measures of real investment rate of return on the real exchange rate. Because Feldstein found them to be insignificant, the two real investment return variables were deleted to conserve degrees of freedom. An equation similar to his is sit - P i t

= 3~o + 3q l~t + ~/27rt'+1 + 3~3b[+1 + "Y4gt+1.

(3)

6In particular, current and lagged money growth, inflation, government spending expectations, budget surplus/deficit expectations,and business cyclevariables were used. 7These results are available from the author upon request.

Effects of Budget Deficits on Exchange Rates

401

Unlike Feldstein, government spending is added here because if the equation only included the surplus/deficit, which is probably correlated with spending, the results could not distinguish between the Ricardian equivalence proposition and the conventional open macroeconomic hypothesis. The analysis is carded out for (sit - sit- 1) rather than sit because sit is nonstationary. Equation (3) then becomes Sit -- S i t _ l = C 0 + ClTTt -~- C2(1£ t -- ~/,t_l) + C3(ffr:+ 1 -- qF:) + cr[bt+ 1 -

b t ] + c4[gte+l - - g t e ] .

(4)

The principal difference between (2) and (4) is that deviations of actual from expected current surpluses/deficits and government spending are specified in (2), whereas changes in expected future surpluses/deficits and government spending are specified in (4). Conventional macroeconomic theory implies that the surplus/deficit coefficients a 3 and c4 in (2) and (4) are positive because decreases in the surplus cause the domestic currency to appreciate and the exchange rate to fall, holding government spending constant. Government spending coefficients a 4 and c 5 should be small or insignificant, assuming surpluses/deficits are constant, because spending is offset by increased tax revenues, thus reducing the crowding-out effect. Alternatively, the Ricardian equivalence proposition implies that surplus/deficit coefficients are insignificant. Government spending coefficients are significantly negative because the intertemporal market-clearing model implies that increases in government spending raise interest rates to induce intertemporal resource reallocations. In open economies, the anticipated rise in the interest rate raises the price of domestic currency instead [Barro (1974, 1981)]. Table 1 summarizes the expected coefficient signs under each hypothesis. Money growth coefficients a I and c 2 should be positive in both cases. This would be true whether increases in money stock depress real interest rates and thus the value of the domestic currency, or increases in money stock raise expected inflation, which increases nominal interest rates, but depresses the value of the domestic currency. Likewise, actual and expected inflation coeffÉcients a2, Cl, and c 3 are positive because the domestic currency's purchasing power falls relative to foreign currencies.

II. Data Annual forecasts are published in semiannual issues of the O E C D E c o n o m i c O u t l o o k starting in 1980, but only one projection per year was used to keep the

Table 1. Expected Signs of Coefficients

Hypothesis Ricardian equivalence Conventional open economy

Budget surplus/deficit a 3 or c 4

Government spending a 4 or c 5

0

-

+

0

402

S . E . Beck

forecast horizon constant between observations. These were taken from December issues from 1980 to 1989. The sample was ended in 1989 to avoid complications caused by German reunification and the British pound's link to the European currency unit. One observation was lost because the series is in differences; therefore, nine observations exist for each country. They were pooled across countries to obtain a sample size of 36, with one country serving as the domestic economy. Explanatory variables are both domestic and foreign variables and arc expressed in differential form) For example, the first nine observations in the U.S. regression are the dollar prices of German marks from 1981-1989, the second nine are the dollar prices of British pounds from 1981-1989, etc. Likewise, the first nine observations on (P-t - P-'/) include /z, = / z Us - p.~;, where #us is the U.S. money growth rate and /z~ is the German money growth rate. The second nine observations include p.~ = / z Us - /z~, where /zB is the British money growth rate. This procedure was followed for all variables for each of the five countries studied here. OECD projections are based on model simulations that incorporate official government projections and OECD staff assumptions (see the Economic Outlook, Technical Annex, Forecasting Technique, various issues). Expected and actual inflation rates were obtained from OECD forecasted and actual changes in the GNP or GDP deflator. The surplus/deficit series was derived from OECD forecasted and actual changes in cyclically adjusted general government financial balances. In (2), the surplus/deficit variable was computed by subtracting the lagged projected change from the actual change. The surplus/deficit variable in (4) was computed by subtracting the lagged projected change from the current projected change and adding the actual change. 9 Projections of government spending as a percent of GNP or GDP were derived from projected growth rates of real government spending and real GDP or GNP. If possible, government spending should be decomposed into permanent and transitory categories because, according to Barro (1981), only the latter affect interest rates a n d / o r exchange rates. However, recent work by Aiyagari, et al. (1992) and Baxter and King (1993) suggest both permanent and transitory government spending affect interest/exchange rates. In any case, because government spending data are not available in this form, changes in total government spending were used. For expected money growth rates /z~', monetary targets were used in the first approach; these were obtained from the OECD Economy Outlook for U.S., Germany, and Japan and from Temperton (1991) for Great Britain. The actual values of the targeted money series were obtained from the International Financial Statistics for the U.S. and Japan, from OECD Main Economic Indicators for Germany, and from Temperton (1991) for Great Britain. When the target was a growth range, then (/z, -/x~') was zero if actual growth fell within the range; otherwise, this variable was set to the difference between actual growth and the closest bound of the target range. 1° In the second and third approaches, where /z~

8This was done to preserve degrees of freedom, although expressing variables in differential form constrains the individual variables' coefficients to be equal and opposite in sign. 9Thus, for (2), ( b t - b t _ 1) - E ( b t - b t _ l l l t _ l) = [bt - E ( b t l l t . - 1 ) l , which is ( b t - b t ) in the foregoing notation. For (4), E ( b , + i - b r l l t ) - E ( b r - bt l i l t - l ) + ( b t - b~-l) = E(bt+ll6) - E ( b t ] I t - O , which is (bt+ 1 - bT). t°Target growth rates were stated for the year starting from the fourth quarter for the U.S. and Germany, the first quarter for the U.K., and varied between the third and fourth quarter for Japan.

Effects of Budget Deficits on Exchange Rates

403

was a function of its lagged value or its lagged value and other variables, growth rates were computed from money plus quasimoney figures obtained from the International Financial Statistics. The ratio of GNP to trend GNP was used to control for the effects of business cycles on exchange rates. 11 The GNP data were obtained from OECD Main Economic Indicators and the trend was computed over 1969-1989. Year-end spot exchange rates were obtained from Wharton Economic Forecasting Associates. One condition for pooling time series data cross sectionally is that variables are identical across countries. In the regressions reported here, the data series are compatible. The money supply data are from the same series across countries from the International Financial Statistics. The OECD series are also comparable across countries (see the Economic Outlook, Technical Annex, National Accounts and Monetary and Fiscal Policy, various issues). 12 Moreover, even if (inevitably) there are some variations between countries' series, all variables are expressed in percentages and defined as changes in expected future levels or deviations of actual from expected levels. This should further reduce intercountry differences. Another condition for pooling data is that the slope coefficients in (2) and (4) are identical across countries. It is preferable to test this condition rather than impose it as is done here, however, the very small number of observations per country makes this infeasible.

III. Estimation Estimates for (2) and (4) appear in Tables 2 and 3. Regressions include budget surpluses/deficits and government spending variables both separately and together b~,cause there may be correlations between them that give misleading significance tests. Estimates in Table 3 were obtained using the instrumental variables technique because of possible simultaneity between inflation and exchange rate changes. 13 In both tables, the signs of the significant surplus/deficit and government spending coefficients are positive and negative, respectively, as hypothesized, except in the U.K. where government spending is positive. The R 2 statistics are similar in magnitude to those obtained by Evans. Durbin-Watson statistics indicate that first order residual autocorrelation is low except in four regressions that exclude significant explanatory variables. Lagrange multiplier tests showed there

11Evans used the logarithm of real GNP and Feldstein used the real GNP growth rate as measure of economic activity. 12Total government spending includes both government consumption and government investment. OECD indicates that the definition of government investment spending varies between countries. Because the U.S. combines government investment and consumption in total spending, the regressions reported in Tables 2 and 3 use total government spending. Regressions also were estimated with government consumption and investment as separate variables. The results indicated consumption was the significant component in cases where total spending was significant. Tables 2 and 3 were then duplicated with government consumption replacing total government spending for two sets of data. One set treated U.S. spending as consumption, the other excluded U.S. data entirely. The results for the first set were very similar to those reported. The results for the second set also were similar except government consumption was significant in the Japanese regression in Table 2 and government consumption and budget deficits were insignificant in the British regression in Table 3. 13All lagged exogenous variables were tested. Instruments ultimately included lagged inflation (U.S., Japan, Gerraany, U.IC, and Canada) and exchange rates (Germany) as well as current exogenous variables.

404

S. E. Beck

Table 2. E x c h a n g e Rate Regressions with C o n t e m p o r a n e o u s Fiscal Policy V a r i a b l e s Asit

= a 0 + a 1 AlL t + az(rr t -

Domestic economy U.S.

Japan

Germany

U.K.

Canada

Trte) + a3(b ' -

b ~ ) + a 4 ( g t - g t ' ) + a 5 ( b u s i n e s s cycle)

a0

al

a2

a~

- 0.018 ( - 0.7411 -0.019 (-0.790) -0.021 (-1/.869)

0.000 (0.080) 0.001 (0.1691 0.000 (/).086)

-0.039 ~ ( - 2.043) -0.031 ( - 1.623) -0.032 ( - 1.65t)

0.013 (0.491 )

-0.061 a -0.001 ( - 2.952) ( - 0.340) - 0.062 a - 0.001 ( - 3.019) ( - 0.199) - 0.06P - 0.001 (-2.957) (-0.380) 0.002 (0.098) 0.003 (0.105) 0.003 (0.136)

-0.024 b ( - 1.8541 - 0.022 b ( - 1.806) - 0,024 b (-1.883)

0.021 (0.794)

- 0.000 (-0.047) -0.001 (-0.354) -0.001 (-1t.1611

- 0.032 b 0.007 ( - 1,834) (0.286) -0,041 a (-2.4191 -0.04P -0.014 ( - 2 . 3 4 2 ) I-0.5511

0.06& -0.001 13.1921 ( - 0 . 5 6 9 ) 0.07P -0.001 (3.6131 ( - 0 , 5 2 5 ) 0.069" -0,001 (3.340) ( - 0 . 5 8 0 )

-0.045 ~' -0,000 (-3.558) (-0,000) -0.039 ~ (-3.0121 -0.039 a 0.005 (-2.9131 (0,265)

0.033 (1.275) 0.006 (0.247) 0.037 11.366)

- 0.036 a (-2.548) -0.031 b (-1.996) -0.038 a (-2.578)

0.001 (0.186) 0.000 (0.011) 0.001 (0.406)

-0.024 ( - 1.377) -0.018 (-0.958)

Durbin Watson

Standard errol

0.28

3.11

2.01

//.1311

0.31

3.55

1.80

0.127

0.32

2.93

1.85

0.128

1.995" 0.23 (2.537) 1,919" 0.24 (2.455) 1.943a 0.25 (2.463)

2.34

1.91

0.t17

2.48

1.94

0.116

2.05

1.97

11.117

1.17

1.85

I).136

2.29

2.07

0.128

1.85

2.01

0.236

11.30 3.30

1.78

0.117

0.33

3.89

11.77

0.114

1.384 b 0.13 (1.8001 -0.040 b 1.56P 0.23 ( - 1 . 9 8 8 ) (2.152) -0.046 b 1.625" 0.24 (-2.0191 (2.187)

0.018 (1.290) 0.019 (1,298)

1.089 11.3411 0.719 (0.855) 0.702 (0.820)

0.34

3.04

1.75

0.116

2.64

2.21

0.134

0,005 (0.227) 0,011 (0.549)

1,534 0.25 (1.672) 1.386 0.14 (1.3411 1.718b 0.26 (1.7411

1.28

1.69

0.144

2.12

2.27

0.136

0,058 a (2.171)

0.060 a (2.202)

F-test

a5

1,907 a (3.307) 0.029 1,67& (1,230) (2.746) 0.033 1.77& 1 1 . 3 7 0 ) (2.833)

0.030 (1.202)

I).019 (0.702)

R2

a~

Figures in parentheses are t-statistics where the null hypothesis is aSignificant at the 95% level. bSignificant at the 90% level.

Note:

ai

=

(J.

was no higher order residual autocorrelation and White's (1980) test detected no heteroskedasticity. The contemporaneous surplus/deficit and government spending coefficients in Table 2 are nearly all insignificant except for German government spending and Canadian surpluses/deficits. Estimates of expected future surplus/deficit coefficients are significant in Table 3 for the U.S., Germany, and Canada. Expected future government spending changes are significant in the Japanese regression, but expected future deficit changes are not. In the Canadian regression, both coefficients are significant. The significance of the U.K. government spending and surplus/deficit coefficients occurs only when both are present; their significance is misleading because it is probably caused by correlations between these two explanatory variables [Maddala (1977), p. 123]. Generally, the estimates show that

405

Effects of B u d g e t Deficits o n E x c h a n g e R a t e s T a b l e 3. E x c h a n g e R a t e Regressions W i t h E x p e c t e d F u t u r e Fiscal Policy Variables A s i t = c 0 d- Cl'R-t --F ¢2 A/2't .at- ¢3 A'/'/'te+1 "b C 4 Abte+ l + c 5 Ag~+ t + C6 (business cycle) Domestic economy U.S.

Japan

Germany

U.K.

Canada

co 0.013 (0.511) - 0.002 (-0.102) 0.012 (0.429)

c1

c2

0.024 b -0.000 (1.712) (-0.125) - 0.230 0.001 (1.536) (0.300) 0.025 -0.000 (1.690) (-0.108)

c3

c4

c5

0.008 0.043 b (0.361) (1.830) 0.002 - 0.001 (0.078) (-0.030) 0.009 0.044b 0.007 (0.387) (1.807) (0.231)

0.031 (0.655) 0.045 (0.966) 0.058 (1.369)

1.92

0.145

0.22 1.72

1.93

0.152

0.29 1.98

1.92

0.148

1.301 (1.389) 1.317 (1.529) 1.159 (1.284)

0.17 1.25

1.45

0.125

0.24 1.86

1.75

0.118

0.25 1.61

1.66

0.120

0.001 -0.006 0.003 0.051 a -0.225 (0.088) ( - 1.399) (0.191) (2.619) ( - 0.266) 0.005 -0.003 -0.017 -0.052 0.386 (0.503) (-0.722) (-0.731) (-1.679) (0.328) 0.003 - 0.006 - 0.006 0.037 - 0.025 - 0.445 (0.235) (-1.213) (-0.222) (1.337) (-0.685) (-0.340)

0.22 1.69

1.93

0.132

0.13 0.62

2.32

0.135

0.20 0.82

2.22

0.132

0.730 (0.713) 0.025 0.870 (1.209) (0.871) 0.048 a -0.085 (2.198) (-0.084)

0.22 1.71

2.09

0.129

0.22 1.68

2.07

0.128

0.34 2.47

1.82

0.118

0.007 (0.245) - 0.000 (-0.012) -0.001 (-0.036)

1.464 (1.276) 0.768 (0.789) 1.222 (1.263)

0.28 2.30

1.51

0.137

0.44 4.66

2.23

0.119

0.50 4.91

2.03

0.115

0.006 -0.003 -0.026 0.023 (0.375) ( - 1.197) ( - 1.626) (1.237) 0.005 - 0.001 - 0.026 (0.334) (-0.510) (1.587) 0.001 -0.003 -0.003 0.043 a (0.090) (-1.247) (-2.000) (2.251) 0.008 0.001 -0.016 (0.684) (0.183) (-0.939) 0.002 - 0.000 - 0.018 (0.219) (-1.390) (-1.213) 0.009 -0.002 -0.026 b (0.941) (-0.585) (-1.713)

0.064 a (3.166) - 0.120 a (-4.568) 0.039 a -0.100 a (2.150) (-3.686)

1.378 b (1.750) 1.936 a (2.529) 1.370 b (1.712)

F- Durbin- Standard R 2 test Watson error 0.29 2.47

-0.056 0.003 -0.003 0.009 0.025 ( - 1.230) (0.218) ( - 0.646) (0.517) (1.156) -0.054 -0.001 -0.002 -0.006 -0.049 b ( - 1.282) (-0.007) (-0.644) (-0.390) ( - 1.973) -0.057 -0.000 -0.003 -0.003 0.015 -0.004 (-1.319) (-0.009) (-0.821) (-0.184) (0.706) (-1.669) -0.026 ( - 0.904) -0.004 (-0.112) - 0.015 (-0.478)

c6

Notes: Instrumental variable estimation used to replace rrt. Figures in parentheses are t-statistics where the null hypothesis is a i = O. aSignificant at the 95% level. bSigniflcant at the 90% level.

e x p e c t a t i o n s o f f u t u r e fiscal p o l i c y h a v e g r e a t e r e f f e c t s o n e x c h a n g e r a t e s t h a n d o c u r r e n t p o l i c i e s . T h e s i g n i f i c a n c e o f t h e d e f i c i t v a r i a b l e i n t h r e e o f five c o u n t r i e s i n Table 3 contradicts the Ricardian equivalence proposition and supports the conventional open economy hypothesis in these cases. Although the coefficients on actual inflation in Table 3 are generally positive, the coefficients on money growth and expected inflation in Tables 2 and 3 are generally negative, rather than positive as hypothesized earlier. All are insignificant e x c e p t (Tr t - 7rte) i n T a b l e 2 f o r all c o u n t r i e s , a n d m"/'/':+ 1 i n T a b l e 3 f o r C a n a d a . 14

t4 Various combinations of inflation and money growth variables were added and dropped from the regressions to check for collinear variables. However, the signs and significance of the coefficients in the original specification were unchanged.

406

~. I~. Beck These negative coefficients are most probably due to the "policy anticipations" effect. Money growth rate changes were found to be positively associated with interest rates in the early to mid-1980s [e.g., see Husted and Kitchen (1985), Evans (1987b), and Tandon and Urich (1987). Engel and Frankel (1984) showed that the dollar was also positively associated with changes in money growth rates. They concluded that the positive correlation of the money growth rate with both interest rates and the domestic currency could only be explained if markets expected an increase in money supply to be offset by a, contractionary monetary policy in the future. This "policy anticipations" effect is likely to have existed than because of the anti-inflationary monetary policies announced by major OECD countries at that time. Therefore, inflation rates higher than anticipated also would create the expectation of a offsetting policy reaction, which explains the negative coefficients for (ort - 7r,) in Table 2. The business cycle coefficients are almost all positive, and they are significant for the U.S., Japan, and Germany in Table 2, but significant only for the U.S. in Table 3. The positive coefficients imply that the domestic currency depreciates during economic booms, possibly due to large trade deficits. To capture the effect of any omitted variables common to all countries, e.g., oil price changes or changes in trade barriers, a time trend was added to all regressions. However, the signs and significance of the other variables were similar to those reported here.

IV. Conclusions This study tested the significance of changes in government budget deficits on exchange rates for five open economies. Two specifications, analogous to Evans' and Feldstein's, were compared. Evans' deficit variable, which measures unanticipated changes in current deficits, was found to be insignificant in all but one case. Feldstein's deficit variable, which measures changes in expected future deficits, was significant in three cases. The Ricardian equivalence implies that deficit variables should be insignificant in either case; hence, these results support the conventional theory more and the Ricardian equivalence theory less than Evans' (1986) results. They are more consistent with Feldstein (1986) and Beck (1993). Like Hodrick, this study failed to duplicate Evans' finding that both government spending and surplus/deficit coefficients are significantly negative in the U.S. Hodrick [(1989), pp. 269-270] had concluded that the VAR methodology was at fault because it does not capture exogenous forces in the economy. However, the similarity of results obtained here, using expectations data that better captures anticipated exogenous events, indicates that Feldstein's criticism is also serious, i.e., that Evans' regression is misspecified. Although estimates for three countries support the conventional hypothesis, the Japanese estimates do not. Moreover, the significant government spending coefficients for Germany in Table 2 and Canada in Table 3 suggest that the forwardlooking, market-clearing intertemporal model has explanatory power in these countries as well. A reason for this may be that the culture, institutions, and policies of these countries are closer to the assumptions underlying the model than others. For example, one assumption is that households have very long planning horizons and have close bonds with succeeding generations. In any case, the evidence here indicates that for other countries, these assumptions are violated

Effects of Budget Deficits on Exchange Rates

407

and expected budget deficits do cause significant appreciation of the domestic currency, thereby transferring the crowding-out effect to the export sector. Thus, budget deficits are rightly the concern of their policymakers.

References Aiyagari, S., Christiano, L., and Eichenbaum, M. October 1992. Output, employment and interest rate effects of government consumption. Journal of Monetary Economics 30:73-86. Barro, R. December 1974. Are government bonds net wealth? Journal of Political Economy 82:1095-1117. Barro, R. December 1981. Output effects of government purchases. Journal of Political Economy 89:1086-1121. Baxter, M., and King, R. June 1993. Fiscal policy in general equilibrium. American Economic Review 83:315-334. Beck, S. April 1993. The Ricardian equivalence proposition: Evidence from foreign exchange markets. Journal of International Money and Finance 12:154-169. Chinn, M. June 1991. Some linear and nonlinear thoughts on exchange rates. Journal of International Money and Finance 10:214-230. Darrat, A. January 1990. Structural budget deficits and interest rates: Some causality and co-integration tests. Southern Economic Journal 56:752-759. Diebold, F., and Nason, J. May 1990. Nonparametric exchange rate prediction? Journal of International Economics 28:315-332. Dornbusch, R. December 1976. Expectations and exchange rate dynamics. Journal of Political Economy 84:1161-1176. Engel, C., and Frankel, J. January 1984. Why interest rates react to monetary announcements: An explanation from the foreign exchange market. Journal of Monetary Economics 13:31-39. Engel, C., and Hamilton, J. September 1990. Long swings in exchange rates: Are they in the data and do the markets know it? American Economic Review 80:689-713. Evans, P. November 1986. Is the dollar high because of large budget deficits? Journal of Monetary Economics 18:227-249. Evans, P. February 1987a. Interest rates and expected future budget deficits in the United States. Journal of Political Economy 95:34-58. Evans, P. September 1987b. Do budget deficits raise nominal interest rates? Evidence from six countries. Journal of Monetary Economics 19:281-300. Feldstein, M. 1986. The budget deficit and the dollar. In National Bureau of Economic Research Macroeconomics Annual. Cambridge, MA: The MIT Press, pp. 355-392. Frankel, J. 1985. The dazzling dollar. Brookings Papers on Economic Activity 1:199-217. Hodrick, R. 1989. U.S. international capital flows: Perspectives from rational maximizing models. In Carnegie-Rochester Conference Series on Public Policy (K. Brunner and A. Meltzer, eds.). Amsterdam: North-Holland, pp. 231-288. Hoelscher, G. February 1986. New evidence on deficits and interest rates. Journal of Money, Credit and Banking 18:1-17. Husted, S. and Kitchen, J. November 1985. Some evidence on the international transmission of U.S. money supply announcement effects. Journal of Money, Credit and Banking 17:456-466. Maddala, G. 1977. Econometrics. New York: McGraw-Hill. Meese, R., and Rogoff, K. February 1983. Empirical exchange rate models of the seventies: Do they fit out of sample? Journal of International Economics 14:3-24.

408

S.E. Beck Plosser, C. May 1982. Government financing decisions and asset returns. Journal of Monetan" Economics 9:325-352. Seater, J. March 1993. Ricardian Equivalence. Journal of Economic Literature 31:142-190, Tandon, K., and Urich, T. March 1987. International market response to announcement of U.S. macroeconomic data. Journal of lnternational Money and Finance 6:71--83. Temperton, P. 1991. UKMonetary Policy. New York: St. Martin's Press. Thomas, L., and Abderrezak, A. July 1988. Anticipated future budget deficits and the term structure of interest rates. Southern Economic Journal 55:150-161. Turnovsky, S. May 1986. Short-term and long-term interest rates in a monetary model of a small open economy. Journal of International Economics 20:291-311. Wachtel, P., and Young, J. December 1987. Deficit announcements and interest rates. American Economic Review 77: 1007-1012. White, H. May 1980. A heteroskedastic consistent covariance matrix estimator and a direct test of heteroskedasticity. Econometrica 48:817-838.