The Role of the Budget Deficit during the Rise in the Dollar Exchange Rate from 1979-1985

Abstract

The U.S. dollar appreciated in value over 40% from early 1979 until it peaked in February 1985.' Also during this period the U.S. federal government budget deficit grew from $16b to $200b. According to Hakkio and Higgins [15] it is high U.S. interest rates and foreign capital inflows into the U.S. that provide the linkage between these two events. There is a considerable debate in the literature as to the precise influence of budget deficits upon these various linkages. Evans [10], for example, suggests that large deficits did not cause the rise in the dollar. Also, there are numerous studies refuting the association between deficits and interest rates; see Evans [11] and Hoelscher [16] for example. On the other hand, Plosser [25] reports a positive association between government spending and interest rates and Hoelscher [17] reports a positive association between deficits and long-term rates. This paper uses an open-economy vector autoregression (VAR) model to investigate these linkages, finding that after controlling for the influence of money, inflation, the dollar, and the trade deficit, there is indeed causality running from deficits to long-term interest rates. The model also identifies a relationship between long-rates and the dollar value, thus verifying the linkage, albeit indirect, of budget deficits and the dollar value. A second concern is that large budget deficits may have led to an accommodative monetary policy causing excessive money growth rates at times. For example, from 1982:07-1983:09 Ml growth averaged 13% and when the dollar value peaked in 1985, Ml was growing at about 12%.2 A number of authors have examined this issue, yet collectively they have not arrived at a uniform conclusion. Ahking and Miller [1] provide a summary of these studies. The majority of these studies suffer from at least one of two faults that I attempt to correct in this paper. In particular, they either suffer from exogeneity problems stemming from single-equation models or they suffer from omitted variable bias due to the exclusion of international variables. Variance decompositions generated from an open-economy VAR indicate that deficits explain more of the variance of the forecast error of money growth than any other variable. The results also verify that deficits affect inflation only through their influence on the money supply.