Abstract

The US Budget Deficit and the Dollar Rate

Since it is highly disputed whether there is a close interrelationship between the US budget deficit and the dollar rate, this contribution examines whether plausible theoretical reasons speak against the relevance of US budget policies in the period of an appreciating dollar rate between September 1980 and March 1985 and in the phase of a declining dollar rate that began in April 1985. Another question raised in this paper concerns the importance to be attached to reducing budget deficits in order to cut the deficit on the US current account.

It would be a fair assumption for the period of a rising dollar rate that the growing deficits in the Federal budgets raised interest rates and the value of the dollar. However, the question must remain open what relative contribution is to be ascribed to fiscal policy in this context. The combined effects of a restrictive monetary policy, of positive earnings expectations and of an expansionary fiscal policy are responsible for the massive appreciation of the dollar rate. The assumption that money creation, extra saving and capital imports have prevented interest rates from rising can be precluded. The critical element in connexion with international capital movements is the interest elasticity of capital flows. Budget deficits lead to national currency appreciation only when elasticity is high; if it is low, the consequence is depreciation, which would then testify of the irrelevance of the US budget deficits to the dollar rate. When assuming a generally high interest elasticity, it is only logical to conclude that the deficits have been associated with rather minor expansionary effects on National Income.

On the other hand, the budget deficits are likely to have been of a rather minor importance in the phase of.a declining dollar rate, because a switch from expansionary to clearly restrictive budget policies began in the course of 1987 only. Since the Gramm-Rudman Bill suggests that there has been a trend reversal in budgetary developments since the end of 1985, it is possible that falling interest rate and declining dollar rate expectations have been conducive to an earlier tendency toward a declining dollar rate.

The elimination of the US budget deficit on the deficit on current account invariably means for the US Government to pursue a restrictive policy. This objective can be reached much more effectively and at amuch higher growth rate by consolidating the budget than by running a restrictive monetary policy so that US policy should focus on reducing budget deficits and on abstaining from monetary policy support of the dollar rate.