The effects of the U.S. budget deficit and inflation on exchange rate.

Author:Kara, Orhan
Position:Report
 
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  1. INTRODUCTION

    The Great Recession (December 2007-June 2009) led to a steep increase in the U.S. budget deficit, which received a renewed attention from both scholars and politicians. Increased government spending with aggressive monetary policies raised concerns over inflation. However, the Fed is currently hesitant to implement policies given that the unemployment rate is still high and that inflation rate is relatively low. When the price level starts increasing, the Fed may take actions, which will result in an increase in interest rate. As a result, the value of dollar will be affected. Although the relationship between budget deficits, inflation, and exchange rate is the subject of many studies, both empirically and theoretically, they produced conflicting evidence and no agreed upon conclusion has been reached.

    Several scholars investigated the relationship between budget deficits and inflation, especially after Friedman's (1968) claim of budget deficits as the main cause of inflation. The general approach to determine the effect of budget deficits on inflation is how the budget deficit is financed (Saleh and Harvie, 2005) although the agreement is that budget deficits tend to lead inflation regardless of how it is financed. For example, Sargent and Wallace (1981) argued that monetary authorities need to monetize the deficit at one point which leads to inflation. Similarly, Dwyer (1984) and Miller (1983) claimed that budget deficits are inflationary, whether they are monetized or not, through an increase in the wealth due to a rise in the value of bonds and through a crowding out effect as innovation of payment system that makes government bonds more substitutable for money (Saleh and Harvie, 2005). Empirical evidence also supported those claims (Ahking and Miller, 1985; Hondroyiannis and Papapetroi 1994 ; Sowa 1994; Metin 1998; Neyapti ,2003). Moreover, empirical evidence also supported the relationship between budget deficit and interest rates (Feldstein, 1982; Dwyer,1982; Kormendi,, 1983; Evans, 1985; Cebula, 1988; Melvin, Schlangenhauf, and Talu, 1989: Knot and deHan, 1999; Cebula, 2003; Saleh and Harvie, 2005; Chen , 2007; and Butt, Rehman, and Azeem, 2010).

    However, when we look at the relationship between budget deficit and exchange rates, and inflation and exchange rates, studies often produced conflicting results (Evans, 1985; Deravi, Gregorowicz , and Hegji, 1995; Arize and Malindretos 1997; Kim, 1998: Darrat, Chopin, and Dickens, 2001; Kara and Nelson, 2003; El-Sakka and Ghali, 2005; Cheng, Taylor, and Weng, 2006; Maria-Doloris, 2009', Butt, Rehman and Azeem,2010). For example, Evans (1985) asserted that large budget deficit did not lead to an increase in the value of the dollar while Melvin, Schlangenhauf, and Talu (1989) concluded that a rise in the budget deficit led to arise in the value of dollar and that a decrease in the budget deficit caused a decrease in the value of dollar. With a vector autoregressive model, Deravi et al. (1995) found that changes in exchange rate led to changes in price levels, specifically exchange rate depreciation leading to inflation by using a data set spanning from 1975 to 1995. Darrat et al. (2001), using cointegration and error correction method, reached similar conclusions over a period of 1973 to 1997 U.S. data. On the other hand, Kim (1998) found a negative relationship between exchange rate and inflation by employing data from U.S. ranging from 1973 to 1995 with a cointegration method.

    Studies that analyzed the relationship by extending data to other countries also produced conflicting conclusions. Arize and Malindretos (1997) investigated the effects of exchange rate variability on inflation over forty one countries by using cross section data and found evidence supporting the hypothesis that exchange rate variability affects inflation. Likewise, El-Sakka and Ghali (2005) concluded that depreciation in Egypt's currency caused inflation in Egypt. In eleven new European Union member countries and a candidate country data, Dolores (2009) also found a positive relation between exchange rate and inflations as Vasicek did (2010). Moreover, Butt et al. (2010) reached the conclusion that the relationships between exchange rate and inflation exists in Pakistan case although the direction is opposite of what other studies found: inflation causes the changes in exchange rates. On the other hand, after examining data from the U.K. from 1958 to 2002, Kara and Nelson (2003) found a little and weak evidence of the relationship between inflation and exchange rate. Finally, Cheng et al. (2006) concluded that there was no causal relationship between exchange rates and inflation measured by Consumer Price Index, for the U.K., Germany, Canada, and Japan.

    In summary, evidence on the relationship between budget deficit and inflation, and exchange rate is mixed, often producing conflicting results. Therefore, this study examines the relationship between the U.S. budget deficits and inflation and the exchange rates. To that end, the next section discusses the model and methodology. The section after that analyses the results. The final section concludes the study.

  2. MODEL AND METHODOLOGY

    In order to investigate the main objective of this study, i.e., the relationship between exchange rates, inflation, and budget deficit, we need to formulate the functional of the relationship. According to studies investigating the determinants of the exchange rates, researchers agreed that the following factors are the main determinants of the exchange rate: Inflation, interest rates, income, and government (Butt et al., 2010). Furthermore, we also look at both nominal and real exchange rates. Therefore, the following functions are established:

    EXC= f(PPI, Y, R, DEF), (1)

    where EXC is exchange rate, PPI is producer price index, Y is real gross domestic product, and DEF is government budget deficit. Exchange rate is defined as the number of units of foreign currency per unit of domestic currency, which means that a decrease in EXC is a depreciation of the domestic currency.

    In order to estimate the relationship between exchange rate, inflation rate, and deficit, we adopted the following model based on the above form:

    [LEXC.sub.t] = a + [bLPPI.sub.t] + [cLY.sub.t] + [dR.sub.t] + e [DEF.sub.t] + [[epsilon].sub.t] (2)

    where the variables are the same as defined above and L before the variables refers to natural logarithm of the variables. et is the error term. In equation (2), we expect an estimate of b to be negative indicating that an increase in prices will cause depreciation of the currency. Estimated sign of c is expected to be positive indicating an appreciation of the currency. However, if an increase in income leads to relatively more imports, the sign could be negative as the demand for foreign currency increases, which leads to depreciation of the domestic currency. D is expected to be positive as a rise in interest rate relative to other countries' rates will lead to a higher return for the investors in domestic country. Finally, the expected sign of DEF can be positive or negative based on the previous research as was explained in the previous section.

    Equation (2) outlines the long-run relationship among the variables of the function. However, we would like to examine the effect of those variables towards to the long run transition, we need to introduce the short-run dynamics into equation (2). In...

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