Debt and Exchange Rates

Abstract

There is a widespread view among financial market participants, policymakers and journalists that budget deficits and increasing government debt lead to a real depreciation of a country’s currency. This view seems to be based on the informal argument that the real exchange rate is a kind of indicator for a country’s expected future economic performance, which is supposed to be adversely affected by budget deficits and increasing debt. However, it is difficult to reconcile this argument with standard models of real exchange rate determination. First, let us briefly recall the results of the conventional macroeconomic textbook model.2 This framework unambiguously predicts that the real exchange rate appreciates in response to a permanent deficit financed increase in government expenditures. Besides the reduction of investment caused by rising interest rates, the corresponding appreciation of the real exchange rate reduces net exports in favour of increased government expenditure. Second, the conventional result is confirmed by equilibrium models of exchange rates pioneered by Lucas (1982). In this type of model the real exchange rate is the ratio of the foreign and domestic marginal utility of consumption. A permanent increase in government expenditure in the home country reduces home consumption and, therefore, increases marginal utility of home consumption, which in turn leads to a decrease in the real exchange rate.