J ECO BUSN 397

1994:46:397-408

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. Alterna-
tively, 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 house-
holds 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 corre-
lation 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 partici-
pants 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 0148-6195/94/$07.00

© 1994 Temple University
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 impor-
tant to market participants. Using his deficit variable, Feldstein found that in-
creased 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 tech-
nique. 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 e
mt= ~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. Al-
though 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

Budget Government
surplus/deficit spending
Hypothesis a 3 or c 4 a 4 or c 5
Ricardian
equivalence 0 -
Conventional
open economy + 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 observa-
tions 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 fore-
casted 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 pro-
jected 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 transi-
tory 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 spend-
ing 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 forego-
ing 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 tech-
nique because of possible simultaneity between inflation and exchange rate
changes. 13 In both tables, the signs of the significant surplus/deficit and govern-
ment 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 - Trte) + a3(b ' - b ~ ) + a 4 ( g t - g t ' ) + a 5 ( b u s i n e s s cycle)

Domestic Durbin Standard

economy a0 al a2 a~ a~ a5 R2 F-test Watson errol

U.S. - 0.018 0.000 -0.039 ~ 0.013 1,907 a 0.28 3.11 2.01 //.1311
( - 0.7411 (0.080) ( - 2.043) (0.491 ) (3.307)
-0.019 0.001 -0.031 0.029 1,67& 0.31 3.55 1.80 0.127
(-0.790) (0.1691 ( - 1.623) (1,230) (2.746)
-0.021 0.000 -0.032 0.021 0.033 1.77& 0.32 2.93 1.85 0.128
(-1/.869) (/).086) ( - 1.65t) (0.794) 1 1 . 3 7 0 ) (2.833)

Japan -0.061 a -0.001 -0.024 b 0.030 1.995" 0.23 2.34 1.91 0.t17
( - 2.952) ( - 0.340) ( - 1.8541 (1.202) (2.537)
- 0.062 a - 0.001 - 0.022 b -0.024 1,919" 0.24 2.48 1.94 0.116
( - 3.019) ( - 0.199) ( - 1.806) ( - 1.377) (2.455)
- 0.06P - 0.001 - 0,024 b I).019 -0.018 1.943a 0.25 2.05 1.97 11.117
(-2.957) (-0.380) (-1.883) (0.702) (-0.958) (2.463)

Germany 0.002 - 0.000 - 0.032 b 0.007 1.384 b 0.13 1.17 1.85 I).136
(0.098) (-0.047) ( - 1,834) (0.286) (1.8001
0.003 -0.001 -0,041 a -0.040 b 1.56P 0.23 2.29 2.07 0.128
(0.105) (-0.354) (-2.4191 ( - 1 . 9 8 8 ) (2.152)
0.003 -0.001 -0.04P -0.014 -0.046 b 1.625" 0.24 1.85 2.01 0.236
(0.136) (-1t.1611 ( - 2 . 3 4 2 ) I-0.5511 (-2.0191 (2.187)

U.K. 0.06& -0.001 -0.045 ~' -0,000 1.089 11.30 3.30 1.78 0.117
13.1921 ( - 0 . 5 6 9 ) (-3.558) (-0,000) 11.3411
0.07P -0.001 -0.039 ~ 0.018 0.719 0.33 3.89 11.77 0.114
(3.6131 ( - 0 , 5 2 5 ) (-3.0121 (1.290) (0.855)
0.069" -0,001 -0.039 a 0.005 0.019 0.702 0.34 3.04 1.75 0.116
(3.340) ( - 0 . 5 8 0 ) (-2.9131 (0,265) (1,298) (0.820)

Canada 0.033 0.001 - 0.036 a 0,058 a 1,534 0.25 2.64 2.21 0.134
(1.275) (0.186) (-2.548) (2.171) (1.672)
0.006 0.000 -0.031 b 0,005 1.386 0.14 1.28 1.69 0.144
(0.247) (0.011) (-1.996) (0.227) (1.3411
0.037 0.001 -0.038 a 0.060 a 0,011 1.718b 0.26 2.12 2.27 0.136
11.366) (0.406) (-2.578) (2.202) (0.549) (1.7411

Note: Figures in parentheses are t-statistics where the null hypothesis is ai = (J.
aSignificant at the 95% level.
bSignificant at the 90% level.

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 coeffi-
cients 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 coeffi-
cients 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
Effects of B u d g e t Deficits o n E x c h a n g e R a t e s 405

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 F- Durbin- Standard

economy co c1 c2 c3 c4 c5 c6 R 2 test Watson error
U.S. 0.013 0.024 b -0.000 0.008 0.043 b 1.378 b 0.29 2.47 1.92 0.145
(0.511) (1.712) (-0.125) (0.361) (1.830) (1.750)
- 0.002 - 0.230 0.001 0.002 - 0.001 1.936 a 0.22 1.72 1.93 0.152
(-0.102) (1.536) (0.300) (0.078) (-0.030) (2.529)
0.012 0.025 -0.000 0.009 0.044b 0.007 1.370 b 0.29 1.98 1.92 0.148
(0.429) (1.690) (-0.108) (0.387) (1.807) (0.231) (1.712)
Japan -0.056 0.003 -0.003 0.009 0.025 1.301 0.17 1.25 1.45 0.125
( - 1.230) (0.218) ( - 0.646) (0.517) (1.156) (1.389)
-0.054 -0.001 -0.002 -0.006 -0.049 b 1.317 0.24 1.86 1.75 0.118
( - 1.282) (-0.007) (-0.644) (-0.390) ( - 1.973) (1.529)
-0.057 -0.000 -0.003 -0.003 0.015 -0.004 1.159 0.25 1.61 1.66 0.120
(-1.319) (-0.009) (-0.821) (-0.184) (0.706) (-1.669) (1.284)
Germany -0.026 0.001 -0.006 0.003 0.051 a -0.225 0.22 1.69 1.93 0.132
( - 0.904) (0.088) ( - 1.399) (0.191) (2.619) ( - 0.266)
-0.004 0.005 -0.003 -0.017 -0.052 0.386 0.13 0.62 2.32 0.135
(-0.112) (0.503) (-0.722) (-0.731) (-1.679) (0.328)
- 0.015 0.003 - 0.006 - 0.006 0.037 - 0.025 - 0.445 0.20 0.82 2.22 0.132
(-0.478) (0.235) (-1.213) (-0.222) (1.337) (-0.685) (-0.340)
U.K. 0.031 0.006 -0.003 -0.026 0.023 0.730 0.22 1.71 2.09 0.129
(0.655) (0.375) ( - 1.197) ( - 1.626) (1.237) (0.713)
0.045 0.005 - 0.001 - 0.026 0.025 0.870 0.22 1.68 2.07 0.128
(0.966) (0.334) (-0.510) (1.587) (1.209) (0.871)
0.058 0.001 -0.003 -0.003 0.043 a 0.048 a -0.085 0.34 2.47 1.82 0.118
(1.369) (0.090) (-1.247) (-2.000) (2.251) (2.198) (-0.084)
Canada 0.007 0.008 0.001 -0.016 0.064 a 1.464 0.28 2.30 1.51 0.137
(0.245) (0.684) (0.183) (-0.939) (3.166) (1.276)
- 0.000 0.002 - 0.000 - 0.018 - 0.120 a 0.768 0.44 4.66 2.23 0.119
(-0.012) (0.219) (-1.390) (-1.213) (-4.568) (0.789)
-0.001 0.009 -0.002 -0.026 b 0.039 a -0.100 a 1.222 0.50 4.91 2.03 0.115
(-0.036) (0.941) (-0.585) (-1.713) (2.150) (-3.686) (1.263)

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 con-
ventional 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 unantici-
pated 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 coeffi-
cients for Germany in Table 2 and Canada in Table 3 suggest that the forward-
looking, 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.

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