Mr. Penati, economist in the Research Department, is a graduate of Bocconi University, Milan, and the University of Chicago.
The author has benefited from the comments of Dale Henderson and Richard Haas, as well as those of colleagues in the Fund.
In his survey of exchange rate models, Isard (1978, p. 26) writes: “It seems safe to assert that open-economy models have provided better insights on the exchange-rate impacts of central-bank policies than on the exchange-rate impacts of fiscal policies.” Since the appearance of this survey, the disagreement on the relation between fiscal policies and exchange rate movements has persisted.
For example, there is disagreement as to whether expansionary fiscal policies directly cause inflation, as to whether bond-financed increases in public expenditure are equivalent to tax-financed increases, and as to whether transitory policies have a larger impact on output than do permanent policies. Boskin (1982, p. 296) writes: “While substantial analytical and, to a lesser extent, empirical improvements have been made in our understanding of the impact of federal government activity on the performance of the economy in the short and long run, clearly nothing like a consensus is emerging and as a profession, strong mutually inconsistent views still dominate.”
Penati (1983) analyzes the relationship among budget deficit, external official borrowing, and the exchange rate.
In this section, perfect capital mobility is assumed. If there were no capital movements, so that the current account had always to be balanced, the conclusions reached in the next subsection would be reversed. For example, see Branson (1976). Zero capital mobility, however, is not pursued in this paper because it is not representative of the industrial countries.
A dot above a variable indicates time derivative.
The main qualitative conclusions about the exchange rate response to an expansionary fiscal policy remain the same if the small-country model is expanded into a two-country model. See Mussa (1979).
The slope of the LL schedule is equal to
The slope of the XX schedule is
x = ph/s
and, as before, it is assumed that a3 is sufficiently small.
The slope of the FF curve is
The slope is always negative, providing that b2 is greater than b1a2∂y/∂s.
In portfolio equilibrium, the private sector does not accumulate assets, and the net flow of savings must be equal to zero. Because the economy is not growing and the budget deficit declines in proportion to gross national product (GNP), the condition of zero savings is equivalent to a balanced current account. McKinnon and Oates (1966) and Turnovsky (1976) constructed portfolio models of the open economy in which both a current account deficit and a budget deficit characterize the long-run solution, even though wealth is an argument of the expenditure function and the economy achieves portfolio equilibrium. This long-run solution occurs because the increase in the newly issued government debt exactly offsets the decline in the domestic stock of foreign bonds, which is caused by the current account deficit, thus leaving the private stock of wealth unchanged. Because these models assume that the current account is in deficit forever, the interest payments on the foreign-owned government debt are boundless. Clearly, this case can be true only if the interest payments on the government debt are neglected. See also Allen (1977) on this problem.
Ceteris paribus, the appreciation will depend on the weight of import prices in the aggregate demand deflator. The smaller the weight, the larger the appreciation. The largest appreciation will then occur in the extreme case in which exchange rate movements do not affect the aggregate demand deflator and, thus, the real stock of money. In this case, which was analyzed by Mundell (1963), the exchange rate must appreciate until output moves back to its initial level.
Argy and Porter (1972) presented an early analysis of how expectations affect the impact of an expansionary fiscal policy on the exchange rate.
The same assumptions about prices and output dynamics are made by Turnovsky and Kingston (1977) in their analysis of the effects of various financial policies on the exchange rate.
In this model, however, the immediate appreciation in the exchange rate “undershoots” the long-run appreciation. See Mathieson (1977).
As Bailey (1971) pointed out, if the government provides the private sector with goods and services that are good substitutes for the goods that it already consumes, there will be no excess demand because the private sector will simply switch from one kind of goods to the other.
Barro (1981) presents some evidence supporting the different impacts of permanent and transitory increases in government expenditures on the level of output.
In their model, the demand for the real money stock depends on the domestic interest rate and real wealth but not on domestic output; private sector savings are a function of the discrepancy between actual and desired wealth; desired wealth is positively related to disposable income; and disposable income is negatively related to the expansionary fiscal policy because, with a deficit, economic agents anticipate the future tax liabilities associated with the issue of government debt. In the model, an expansionary fiscal policy permanently reduces the private sector disposable income and, hence, desired wealth. As a result, less money is demanded. The equilibrium in the money market is restored by a depreciation that causes an increase in the price level.
In Obstfeld (1981), government expenditure differs from transfers because the authorities can finance a deficit through money creation, which is kept constant here.
The result of a depreciation does not change if households’ utility depends on the level of government expenditure and if the marginal utility of government expenditure does not exceed the marginal utility of private consumption (Obstfeld, 1981).
This result can easily be seen in equation (16) by setting ẇ = 0 and by recalling that c and πm are constant in the long run.
The size of the traded goods sector can be approximated by the ratio of the value added in agriculture, mining, and manufacturing to the gross domestic product at factor costs.
Because the economy produces traded and nontraded goods, total output can be expressed in terms of either one. Thus, for any given production of traded and nontraded goods, changes in their relative price affect total output, and thus the demand for real cash balances. It is assumed that this effect is negligible. An alternative way to solve the problem is to choose a numeraire arbitrarily. For example, see Dornbusch (1976 b).
A similar assumption is made by Mundell (1971) in his analysis of a devaluation in a model with nontraded goods.
If the expansionary fiscal policy is temporary so that the relative price of domestic goods is expected to decline after a while, then the current account deficit will be dampened by an increase in the domestic real rate above the world rate that will induce consumers to defer their expenditures (Dornbusch, 1983).
Portfolio models of exchange rate determination have been also derived in a utility-maximization framework. For example, see Dornbusch (1980 a).
Because nonresidents hold domestic-currency bonds, the current account is equal to
As in monetary models, an expansionary fiscal policy will probably generate expectations of a long-run depreciation that, in turn, will put upward pressure on the exchange rate in the short run. Because this expectation effect is the same as in monetary models, it has been disregarded here.
This approach is well summarized by Tobin (1982, p. 121): “A U.S. government deficit increases the supply of Treasury obligations. Some of them may be bought by taxpayers as the best hedge against the taxes they foresee will be needed to service the debt. But most likely there is a net increase in private wealth, and at prevailing interest and exchange rates, U.S. investors will not wish to absorb all of it in government bonds or even in dollar assets. An increase in the dollar interest rate on bonds and a decline in the dollar against other currencies will place some of the bonds overseas. This is a rationale for the time-honored conservative view that loose fiscal policy endangers or actually depreciates the currency.”