The Budget Deficit and the Dollar

Abstract

This study examines the reasons for changes in the real exchange rate between the dollar and the German mark from the beginning of the floating rate regime in 1973 through 1984. The econometric analysis focuses on the effects of anticipated structural budget deficits and monetary policy in the United States and Germany and the changes in U.S. profitability induced by changes in tax rules. The possible impact of a number of other variables is also examined. The evidence indicates that the rise in expected future deficits in the budget of the U.S. government has had a powerful effect on the exchange rate between the dollar and the German mark. Each one percentage point increase in the ratio of future budget deficits to GNP increased the exchange rate by about 30 percentage points. Changes in the growth of the money supply also affect the exchange rate. Changes in tax rules and in the inflation-tax interaction that altered the corporate demand for funds did not have any discernible effect on the exchange rate. A separate analysis confirms that there is an equilibrium structural relation between the dollar-DM exchange rate and interest rates in the United States and Germany. An increase of one percentage point in the real interest rate differential has been associated with a rise in the DM-dollar rate of about 5 percent.