The effect of budget deficits on exchange rates: Evidence from five industrialized countries

Abstract

Evidence of insignificant correlations between budget deficits and interest rates has been interpreted as support for the Ricardian equivalence proposition. Alternatively, 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.