US budget deficits, inflation and exchange rate: a cointegration approach

Abstract

This paper applies the well-known cointegration approach to explore a possible long–run pairwise relationship between (i) US real budget deficits and real exchange rates, and (ii) US inflation rates and real exchange rates. The unit root test shows that each of the above time series is non–stationary in levels. It is also verified that stationarity can be induced in each series by the first differencing of the level data. The ADF test results indicate a lack of cointegration between the US real budget deficits and the real exchange rates at 1, 5 and 10% levels of significance. The same is also true for US inflation rates and real exchange rates. But these findings have been contradicted by those from the associated error–correction models at 5 and 10% levels of significance. The estimates of the error–correction models offer evidences to long–run/short–run unidirectional Granger causality from the real budget deficits to the real exchange rates, and from the real exchange rates to the inflation rates.