Budget deficits and the exchange rate

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DEPARTMENT O F ECONOMICS E U I W O R K I N G P A P E R BUDGET AND TOE EXCHANGE by

Em i! Claassen / Melvyn Kraus *

* New York University and Hoover Institution (Stanford). The paper was prepared during his stay at the EUI in April/May 1984.

BADIA FI ESO LANA, SAN DOMENICO (F I )

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A ll righ ts reserved. No part o f th is paper may be reproduced in any form without

permission o f the author.

(C) Emil Claassen and Melvyn Kraus Printed in Ita ly in March 1986

European U niversity In stitu te Badia Fiesolana - 50016 San Domenico (F i) - © The Author(s). European University Institute. Digitised version produced by the EUI Library in 2020. Available Open Access on Cadmus, European University Institute Research Repository.

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I . Introduction

In the recent lit e r a tu r e on f l e x i b l e exchange r a te s , atten tion has been focused prim arily on monetary p o lic y . F is ca l p o lic y , in

p a rticu la r, has been afforded scant a tten tion . Moreover, unlike the case o f monetary p o lic y where there is a consensus as to the e f f e c t monetary p o lic y i s lik e ly to have on currency exchange r a te s , the various a r t ic le s dealing with f i s c a l p o licy are not unanimous with respect to the exchange-rate e f f e c t s . This is evident from the recent survey by Penati (1983).

In the f i s c a l p o licy lit e r a t u r e , an important assumption concerns the degree of s u b s titu ta b ilit y between domestic and fo r e ig n fin a n cia l a s sets. There are two lim itin g cases: that o f zero s u b s t it u t a b ilit y , and p erfect s u b s titu ta b ilit y . In the f i r s t case, the tr a d itio n a l flow models o f the 1960s predict a depreciation o f the domestic currency when there is an expansionary, bond-financed f i s c a l p o lic y sin ce the trade balance has to remain in equilibrium . The second case, form erly c a lle d perfect ca p ita l m ob ility , leads to an opposite r e s u lt . Currency appreciation i s necessary to e q u ilib ra te the goods market, since accommodating ca p ita l flows guarantee an o v e ra ll equilibrium in the balance o f payments. Consequently, any in-between case o f imperfect ( l . e . , non-zero and n on -p erfect) s u b s titu ta b ilit y o f domestic and foreig n assets gives r is e eith er to a depreciation or an ap precia tion , depending on the degree of in teg ra tion of the domestic fin a n cia l market w ithin the in tern a tion a l economy.

In th is a r t i c l e , we sh a ll focus on the s p e cia l case o f p erfect s u b s titu ta b ilit y between domestic and foreig n fin a n cia l assets which is relevant to small open economies whose fin a n cia l markets are highly

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integrated with the world ca p ita l market. As is already well-known from tra d ition a l models (se ctio n I I ) , th is assumption permits a sim plication o f macroeconomic models since the domestic in te r e st rate can be assumed to be given by the r e s t o f the world. The advantage o f th is assumption is that i t allow s ab straction from p o r t f o li o an alysis.

Following studies by Dornbusch (1976), Frenkel (1976), Dornbusch and Fischer (1980), and Branson and Buiter (1983) on the n ecessity of a long-run stock equilibrium , se ctio n I II analyzes the path o f the

exchange rate from an i n i t i a l appreciation to a fin a l depreciation given a f is c a l p o licy shock. Since a current account d e f i c i t decreases net fin a n cia l wealth, and thus reduces expenditures on domestic goods, the subsequent excess supply in the goods market i s elim inated mainly by a depreciation o f the domestic currency. Furthermore, there are inherent eq u ilib ra tin g fo r ce s leading to an equilibrium in the current account. Exchange-rate expectation s, introduced in section IV, which are assumed to be o f the ra tion a l type w ill only dampen the i n i t i a l appreciation e f f e c t , whereas the fin a l depreciation rate w ill remain unaffected.

In section V, we take in to account the government budget constrain t as elaborated by Sachs and Wyplosz (1984). Considering f i r s t government bonds as a net wealth item, the i n i t i a l f i s c a l impulse is am plified by the p o s itiv e wealth e f f e c t on private expenditures, leading to a continuous increase in the exchange r a te . On the other hand, i f government bonds do not con stitu te net wealth and i f the government budget i s balanced over the long run, there w ill be no exchange rate e f f e c t o f an expansionary f i s c a l p o lic y .

In the concluding section VI, we sh all emphasize the rea l (as compared with the fin a n cia l) determinants o f the exchange rate which are

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p a rticu la r fo r a model characterized by the assumption o f p erfect s u b s titu ta b ilit y between domestic and foreign a s se ts. F in a lly , we sh a ll in d ica te other r e s t r ic t iv e assumptions fo r which the proposed model is v a li d . © The Author(s). European University Institute. Digitised version produced by the EUI Library in 2020. Available Open Access on Cadmus, European University Institute Research

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I I . The Tradition al IS-LH Model

In a sm all, open economy fo r which the le v e l o f the in te r e s t rate is assumed to be given by the r e s t o f the world, any bond-financd budget d e f ic it produces an appreciation o f the domestic currency. The fam iliar argument runs as fo llo w s : The budget d e f ic it caused by an increase in public expenditures creates an excess demand fo r goods. To the extent that there i s f u l l employment, the excess demand cannot be s a t is fie d by an additional output o f domestic goods.

Since the in te r e st rate i s that o f the world economy, a r is e in the domestic in te re st rate is excluded.1 This excludes crowding-out of domestic private expenditures in favor o f pu blic expenditures via an in te r e s t-ra te e f f e c t . Assuming also a constant p rice le v e l, another crowding-out e f f e c t via the w ea lth -effect can be disregarded.

Consequently, the only way to s a t is fy the ad ditional pu blic expenditures is through the foreig n sector of the goods market.

The mechanics o f the s a t is f ic in g process are as fo llo w s : The excess demand in the market fo r domestic goods is eliminated by currency appreciation which decreases exports and increases im ports. The ad ditional pu blic expenditures on domestic goods are s a t is fie d by more a v a ila b le exportable goods fo r internal use and more a v a ila b le import su bstitu tes being replaced by ad ditional imports. The domestic currency w ill appreciate by such an amount, at which the budget d e f i c i t equals the trade-balance d e f ic it (provided, of course, that the trade balance was i n i t i a l l y in equ ilibriu m ).

The assumptions with resp ect to an unchanged in te r e st rate are discussed in section I I I . 1 © The Author(s). European University Institute. version produced by the EUI Library in 2020. Available Open Access on Cadmus, European University Institute Research Repository.

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The above argument can be Illu s tr a te d form ally by the tr a d itio n a l Mundell model (1963):

L ( r ,y ) * M [LM schedule] (1) y - E ( r ,y ) + G + T (E ,e) [IS schedule] (2) where Tg 0> > o and where

L - demand fo r money, M =■ supply o f money, y • domestic output,

E » domestic private expenditures on domestic and foreign goods,

G » p u b lic expenditures on domestic goods, T - trade balance (exports minus im ports), r ■ in te re st r a te ,

e - exchange r a te .

The sum o f E and G represents to ta l absorption, so that E + G + T is the to t a l demand (by residen ts and foreig n ers) fo r domestic goods whereas y i s the supply o f domestic goods.

Since the domestic in te r e st rate (r ) i s given by the world economy ( r * ) , the equilibrium con dition of the money market determines real income ( y ; see the upper panel of F ig . 1). We assume that y is the domestic output at f u l l employment when i t is not s p e c ifie d otherw ise. Any remaining disequilibrium in the market fo r domestic goods w ill be eliminated by a change in the exchange ra te . For a given le v e l of pu blic expenditures (GQ) , the exchange rate which e q u ilib ra te s the goods market i s eQ (See lower panel of F ig . 1 ). Thus, under the assumption o f p erfect s u b s titu ta b ilit y of domestic and fo re ig n fin a n cia l a s se ts, the exchange rate is determined e x clu siv e ly by the rea l sector o f the

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6 r Figure 1 © The Author(s). European University Institute. version produced by the EUI Library in 2020. Available Open Access on Cadmus, European University Institute Research Repository.

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economy, l . e . , by the IS schedule. An increase o f p u blic expenditures from Gq tQ 3h lf ts the js schedule to the dotted lin e , producing a f a l l in the equilibrium exchange rate from eQ t0 6 l _ The appreciation crowds out fo re ig n e rs' demand fo r domestic goods (le s s exports) and re sid e n ts ' private demand fo r import-competing products (v ia more imports) such that the ad dition a l demand fo r domestic goods by the pu blic sector (dG) creates a corresponding trade-balance d e f i c i t :

dG ■ - I de. _e (3)

As far as the balance o f payments i s concerned, i t i s always in equilibrium at any exchange rate since any trade-balance d e f i c i t is financed by accommodating ca p ita l in flow s.

The tr a d itio n a l lite r a tu r e based on M undell's an alysis goes no fu rth er than t h is — budget d e f ic it s unambigously appreciate the domestic currency ( i . e . , always under the assumption o f p e rfe ct s u b s titu ta b ilit y between domestic and foreign a s s e ts ). However, as w ill be shown, the ap preciation is only a short run consequence o f the budget d e f i c i t . Over time, the appreciation w ill be reversed, and in the long run there w ill be a depreciation o f the domestic currency by comparison with the i n i t i a l le v e l o f the exchange r a te . © The Author(s). European University Institute. Digitised version produced by the EUI Library in 2020. Available Open Access on Cadmus, European University Institute Research

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I I I . Foreign Indebtedness and the Exchange Rate

The argument fo r a long-run depreciation o f the domestic currency Is based on the wealth e f f e c t on private expenditures. The trade-balance d e f i c i t Implies ca p ita l in flow s, which reduces fin a n cia l wealth, and thus, private expenditures. Lower private expenditures release parts of domestic products fo r s a tis fy in g ad ditional pu blic expenditures. As a consequence, future trade-balance d e f ic it s fo r fin an cing government expenditures should decrease in order to maintain equilibrium in the goods market. The I n it ia l appreciation w ill be reversed. In the long run, the trade-balance d e f ic it s vanish by a s e r ie s o f depreciations and they are replaced by an excess supply o f domestic goods being made a v ailab le fo r pu blic expenditures by a f a l l in priv ate expenditures. The f in a l le v e l o f the exchange ra te w ill be above the i n i t i a l one when the f u l l stock equilibrium (a lower stock o f foreig n fin a n cia l assets) has been established autom atically. The trade balance has to be p o s itiv e (to the extent that i t was in equilibrium at the ou tset) in order t o finance ad ditional in terest payments to fo re ig n cou n tries.

When taking in to account the wealth e f f e c t on private expenditures, the equilibrium condition o f the goods market (2) has to be m odified in the follow in g way:

y - E (r,y,W ) + G + T (E ,e) [IS schedule] (A) W stands fo r net fin a n cia l wealth which is composed o f the

outstanding stock o f money and net foreign assets (F ):

W = M + F . (5)

Since the quantity o f money i s assumed to be constant, any change in wealth a rises from a change in the stock of net foreig n assets

(dW = dF). Private expenditures are an increasing fu nction o f wealth

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(Ey > 0 ) . The impact o f a change in wealth on the trade balance is in d ire ct because a c e te r is paribus increase in wealth r a ises private expenditures (dE = Ey dF) and higher private expenditures deteriorate the trade balance (T dE - T E dF where T < 0 ) . A change in wealth

cl b W b

(dF) is produced by the imbalance in the current account o f the balance o f payments:

dF = T(E,e) + r*F [ - 0 ] [CA schedule] (6) To the extent that the current account is not balanced, a change in F feeds back on the conditions in the goods market (A ), provoking a change in the exchange rate sin ce the value fo r r and y are predetermined.

The equilibrium condition o f the goods market (A) is represented by the IS schedule in F ig. 2. Departing from any point on the IS schedule, an increase in F creates an excess demand fo r domestic goods which is eliminated by a f a l l in the exchange rate which decreases exports and in creases imports:

de I EW+ TEEW

s U ' " — —

<o

e

where, in absolute terms, Ey > TgEy. The equilibrium con dition o f the current account (6) , the CA schedule, is also negatively shaped. Again taking any point on the CA schedule, a r is e in F improves the current account through higher in te re st payments from abroad which are partly o f f s e t by a d eteriora tion o f the trade balance ( T E dF) . The surplus of

b W © The Author(s). European University Institute. Digitised version produced by the EUI Library in 2020. Available Open Access on Cadmus, European University Institute Research

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e

Figure 2

the current account can be elim inated by an appreciation which worsens the trade balance:

dF | a ' " < 0 e

To the extent th a t, in absolute terms, r* - TgE^, the CA schedule would be a horizontal lin e : an increase in F leads to a r is e o f foreign in te r e st payments from abroad which are ex actly matched by a d eteriora tion in the trade balance through the wealth e f f e c t on imports. S ta b ility con dition s require that the slope o f the CA schedule i s lower than the slope o f the IS schedule, both measured in absolute terms, i . e . , that

r* < Ew (7)

Thus, fo r instance, any poin t on the IS schedule rightward from the

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in te r se c tio n point A im plies a d e f i c i t in the current account so that the system moves back towards A. I f , on the contrary, the CA schedule is steeper than the IS schedule, there would be a surplus in the current account and the system would move further rightward (Sachs and Wyplosz, 19814).

F ig . 3 represents a combination o f F ig. 2 with the lower panel of F ig . 1. The s o lid lin e s describe the i n i t i a l equilibrium at point A before government expenditures are increased. For reason o f s im p lic it y , we assume that the i n i t i a l stock o f net fin a n cia l assets (Fg) zero- A r is e in government expenditures from GQ t0 Gl produces the

appreciation o f the domestic currency from e^ p0 (see point B) according to the Mundell model. At point B, the current account is in d e f i c i t , wealth is decreasing, and thus, private expenditures are f a l l i n g . The equilibrium con dition in the goods market require a lower trade-balance d e f i c i t which is brought about by an increase in the exchange r a te . In the righthand panel o f F ig . 3, the system moves on the IS (G.|) schedule gradually towards point C, where the current account i s in equilibrium and net foreig n indebtedness reaches the le v e l F j. In the lefthand panel, the IS schedule fo r the lower wealth le v e l s h ift s towards the p osition ISCG^ f, ) .

With respect to the i n i t i a l exchange rate (e g ), the domestic currency has been depreciated by e,,-eg , i . e . , by

de _ r* + TeEw dG _{(EW * r * )Te} ( 8 ) © The Author(s). European University Institute. Digitised version produced by the EUI Library in 2020. Available Open Access on Cadmus, European University Institute Research

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e e

Figure 3

The expression (8) i s derived from the equilibrium conditions (U) and (6) . Formula ( 8) is p o s itiv e to the extent that the s t a b ilit y condition (7) h olds. The long-run depreciation takes place provided that r* +TEEW > 0 , according to which the higher indebtedness worsens the current account (the increase in in te re st payments i s higher than the improvement o f the trade-balance via lower im ports). Consequently, a depreciation has to occur in order to create a trade-balance surplus ( i n i t i a l l y , i t was assumed to be in equilibrium ) which is s u ffic ie n t to honor the In terest serv ice on foreign debt. The exchange rate would

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remain unchanged i f r* + TgEy - 0, i . e . , i f the in te re st payments on the ad dition a l debt are o f f s e t by a trade-balance surplus induced by the reduction o f imports via the wealth e f f e c t . F in a lly , there can be an appreciation provided that r* ♦ T ^ < 0i whlch meana that the

trade-balance surplus created by the wealth e f f e c t exceeds the in terest payments on foreign debt.^

To summarize, an expansionary f i s c a l p o licy leads to an appreciation o f the domestic currency in the sh ort-run, but to a depreciation in the lon g-ru n. Due to the assvmiption that the monetary sector always remains in equ ilibriu m , the downward and subsequent upward movement in the exchange rate arises from the eq u ilib ra tin g fo r ce s within the real sector (goods market and current accoun t). At the very beginning o f the expansionary f i s c a l p o lic y , the economy as a whole consumes more goods than i t produces, and the extra goods are provided by a rea l tran sfer from abroad. However, there are automatic fo r ce s which maintain the cou n try's long-run external budget con stra in t. The rea l tra n sfer w ill be paid fo r eventually by a gradual reduction in private absorption (v ia the wealth e f f e c t of foreig n indebtedness) which produces a s e r ie s of d e p re cia tio n s.

IV. The Role o f the Monetary Sector

That the monetary se c to r plays a passive r o le in the determination o f the exchange rate a rises from the assumption that domestic and fo re ig n fin a n cia l assets are p e r fe ct su b stitu tes. However, two in flu en ces resu ltin g from a change in the demand f o r money on the

I t should be noted that at the new long-run equilibrium poin t C, the ad dition a l government expenditures (Ag) are com pletely financed by a f a l l in priv ate expenditures. Since the trade-balance must be in surplus, the reduction in private expenditures finances not only the budget d e f i c i t , but a lso the trade-balance surplus (AG + AT = - AE).

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IH

exchange rate are conceivable. The f i r s t one produces only a temporary Impact, and the second one revea ls a permanent e f f e c t on the exchange r a te .

The short-run Influence o f the money market on the exchange rate is caused by a temporary increase in the domestic in te r e st rate (r ) above the world in te re st rate (r * ) according to the in te r e s t-r a te parity (IRP):

r - r* + ! --- ®

[

irp schedule] (9) e

The la s t term in formula (9) stands fo r the expected change in the exchange r a te , where e represents the expected exchange r a t e . The in te r e s t-ra te pa rity i s illu s tr a te d by the IRP schedule (Claassen, 1983) in the righthand panel o f F ig . H fo r a given in tern a tion a l in terest rate (■"*) and fo r a given expected exchange ra te ( i - eQ) . i t s slope is equal to

de | dr I IRP

To the extent that the actual exchange ra te is below the expected one (e < e ) , there w ill be an expectation o f a d ep reciation , and the domestic in te re st rate lle 3 above the in ternation al one (r > r*) by the amount of the expected depreciation r a te . There is no r is k premium since we a3sune ra tion a l expectations according to which the expected change in the exchange rate is equal to the actual change.

The I n it i a l equ ilibrim i is at point A in both panels o f F ig . H ( e0 » e and r Q . r * ) . The increase in government expenditures leads to

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the short-run appreciation e^ (poin t B in the lefthand panel) and to the long-run depreciation o f e2 (poin t C ). Long-run expectations about the exchange rate are revised from 5 - e Q to e - e2 and the IRP schedule s h ift s towards the dotted lin e . At point B, the expected rate of depreciation is ( e 2_e ^) / e-j, which corresponds to the in te r e s t-ra te d iffe r e n t ia l r^ - r * . The domestic in terest rate must r is e ; otherwise the rate o f return on domestic fin a n cia l assets would decrease in comparison to the in ternation al one, and the ad dition a l pu blic debt would not be bought by the residen ts o f the country.

At point B, the goods market i s in disequilibrium because the r is e in the domestic in te re st rate creates an excess supply of goods f o r two reasons. F ir s t , by relaxin g the assumption o f f u l l employment, output w ill r is e since there is an excess supply o f money as a consequence of the in te r e st rate-induced f a l l in the demand fo r money. Second, priv ate expenditures are also f a l lin g as a resu lt o f the higher in te re st r a te . Consequently, the s iz e o f the i n i t i a l appreciation (point B) which was necessary to elim inate the government-induced excess demand fo r goods w ill be lower such that the appreciation w ill be s e t t le d , fo r instance, at point B' instead o f point B.3 as fa r 33 p^e long-run exchange-rate le v e l is concerned, i t continues at point C sin ce the domestic in te r e st rate is only higher over the adjustment process from B' to C, during which the in te re st rate f a l l s continuously u n til i t has reached the world in te r e st le v e l r * . Thus, by taking in to account the short-run r is e in the domestic r a te , the path o f the exchange ra te w ill be

Since we assume an instantaneous adjustment process in the goods market (and, a f o r t i o r i , in the money market), the movement o f the exchange rate w ill be that o f A to B' and not from A to B and then from B to B '.

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modified (see the arrows in F ig . *0, it s fin a l quillbrium le v e l, however, remains unchanged.1*

Figure *t

In exchange-rate models with im perfect s u b s titu ta b ilit y o f domestic and foreig n fin a n cia l assets ( " p o r t f o l io m odels"), both the i n i t i a l

appreciation rate and the fin a l depreciation rate are dampened sin ce the domestic in te re st rate r is e s in the short run and in the long run, leading to an in te r e s t-ra te induced crowding-out o f private expenditures. Consequently, the f i s c a l stimulus remains lower even though output in cre a s e s, sin ce the demand fo r money decreases with a higher in te re st rate (Branson and B uiter, 1983 and Sachs and Wyplosz, 198*1. © The Author(s). European University Institute. version produced by the EUI Library in 2020. Available Open Access on Cadmus, European University Institute Research Repository.

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A la stin g long-run impact from the money market on the exchange rate a rises when the demand f o r money depends on wealth, as stressed in the exchange-rate models o f Dornbusch and Fischer (1980) and Boyer and Hodrick (1982). Since the current account i s in d e f i c i t during the adjustment period in volvin g a decixnulation o f wealth, the demand for money decreases and money-market equilibrium requires a continuous increase in output over the tr a n s itio n period when the full-employment assisnption is relax ed . Whereas the i n i t i a l ap preciation follow in g the f i s c a l stimulus w ill be the same, the depreciation rate at the fin a l f u ll- s t o c k equilibrium i s stronger than the depreciation without the wealth e f f e c t in the money-demand fu n ction , provided that the response o f the money demand with respect to wealth is high. Under th is

c on d ition , the excess supply in the money market w ill be la rg e , leading to a strong output e f f e c t and, by t h is , to an ad dition a l excess supply o f goods which is elim inated by a higher ra te o f d e p r e cia tio n .5

5

By including the wealth variable in the demand fu n ction fo r money o f equation ( 1 ) , the d iffe r e n t ia l o f the equilibrium con dition s ( 1 ) , ( 4 ) , and (6) in dicates the follow in g depreciation rate fo r the long run:

de.^ W W V V

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dG [E ^ -r*+ (1-E y)(L^/Ly)]Tg

For * 0. we obtain the expression o f formula ( 8 ) . I f Lu is r e la t iv e ly la rg e , then (8a) > ( 8 ) . © The Author(s). European University Institute. Digitised version produced by the EUI Library in 2020. Available Open Access on Cadmus, European University Institute Research

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V. Public Indebtedness and the Exchange Rate

To th is p oin t, we have neglected that the o n ce -a n d -fo r -a ll r is e o f government expenditures from to gives r is e to a continuous increase in public indebtedness, since the ad dition a l government expenditures were assumed to be financed on the domestic cre d it market. To the extent that government bonds (B) are considered to represent net fin a n cia l wealth,

W - M + B + F, (10)

there w ill be a supplementary demand impulse on the market fo r domestic goods since private expenditures are an in creasin g fu n ction o f wealth. As a r e s u lt , both the s iz e of the i n i t i a l rate of appreciation and the size o f the fin a l rate o f depreciation must be higher. In F ig . 5, the government-expenditures e f f e c t and the wealth e f f e c t are illu s tr a te d sep a ra tely. The f i r s t one is known from F ig . 3 and the exchange-rate path is from A to B and from B to C. The ad dition a l wealth e f f e c t produces the tr a je c to r y from A to B' and from B' to C '. I t should be noted that the CA schedule s h ift s upward since the Increase in wealth from Bq tQ worsens the trade balance. The reason fo r the higher depreciation rate at point C' is that the ad dition a l demand impulse a ris in g from the wealth e f f e c t creates a stronger cumulative d e f ic it in the current account during the tra n sitio n p eriod. Consequently, the economy ends up with a higher le v e l of foreign indebtedness. The in te re st payments on foreign debt are higher such that the trade- balance surplus must be la rg e r, which i s brought about by a greater depreciation r a te . © The Author(s). European University Institute. version produced by the EUI Library in 2020. Available Open Access on Cadmus, European University Institute Research Repository.

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e

Figure 5

The adjustment process does not stop at point C ', however. Public debt continues to in crease, and over time the IS schedule s h ift s continuously downward and the CA schedule continuously upward— both move s te a d ily at the rate o f Increase o f pu blic debt. I t fo llo w s that there w ill be a continuous increase in the exchange rate according to the arrow in F ig . 5.

Consequently, a permanent budget d e f i c i t — at le a s t in our framework o f a station a ry economy— creates a s t a b ilit y problem which i s already well-known from the lite r a tu r e fo r a closed economy (C h rist, 1979;

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Mayer, 1984). In the context of an open economy, there would be an endless r is e in the exchange rate which could even become exp losive i f one introduces exchange-rate expectations.

In order to solve the s t a b ilit y problem, one has to introduce the constrain t of a balanced government budget in the sense o f a lim ited le v e l of government indebtedness (Sachs and Wyplosz, 1984); otherwise the in te re st se r v ice on pu blic debt w ill grow in f in it e l y over the distant fu tu re. Given that in our model the pu blic indebtedness in volves a fo re ig n indebtedness, the lim it o f p u blic indebtedness is also set by the lim it o f foreign indebtedness. Increasing government debt im plies increasing foreign debt, and there is a lim it to the size o f the trade-balance surplus (and, thus, to the s iz e o f the f a l l in private a b sorption ); otherwise the ev er-in crea sin g amount of in terest payments on foreign debt would have to be financed by an ever increasing trade-balance surplus (which, by the way, involves an ever increasing exchange r a t e ).

By se ttin g the to le ra b le s iz e o f pu blic indebtedness to a f in it e le v e l B) the increase in government expenditures has to be financed either by ad ditional taxes when the pu blic debt has reached the upper lim it B, or be reduced to the i n i t i a l le v e l G in both cases, by n eglectin g the wealth e f f e c t o f ad dition a l government bonds, the system has to return to point A in F ig . 5. For the very long run, the temporary f i s c a l stimulus would be neutral both with respect to the exchange rate and the le v e l of foreign indebtedness.6

^The case o f an increase in taxes has to be conceived in such a way that the expansionary impulse o f ad ditional government expenditures on the demand fo r domestic goods is o f f s e t by the r e s t ic t iv e impact o f higher

(Footnote continued) © The Author(s). European University Institute. version produced by the EUI Library in 2020. Available Open Access on Cadmus, European University Institute Research Repository.

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On the other hand, i f one takes in to consideration the wealth e f f e c t o f the ad ditional government bonds (AW = AB =■ B-BQ where Bq 1s the I n it i a l le v e l of government d e b t), there w ill be a depreciation rate of

t .

r*(vw

dB (Ew-r * ) Te

(11)

compared to the i n i t i a l exchange rate eQ which f i s c a l p o lic y became a c tiv e . Formula (11) r e su lts from a d iffe r e n t ia tio n of the equilibrium condition s (A) and (6) fo r the wealth d e fin it io n (10) and fo r dG - 0. Under the s t a b ilit y condition ( 7 ) , the expression (11) is p o s itiv e , but i t is smaller than (8) (fo r dB =■ dG even though AB = B - Bq „ £flG). The in terp reta tion f o r the long-run depreciation i s straightforw ard. Even though the long-run government budget i s balanced, the past f i s c a l "experiments" have produced not only a higher le v e l o f pu blic debt, but a higher le v e l o f foreign debt where

dF

E_W E_W r*

dB (12)

During the adjustment process, the current account i s in d e f i c i t — th is gives r is e to a higher le v e l o f fo re ig n indebtness. The increased amount o f in te r e st payments on foreign debt must be financed by a corresponding trade-balance surplus brought about by the depreciation of the domestic curren cy.7

^(continued) ta x e s. 7

I t should be noted th a t, according to (1 2 ), /dF/>dB, i . e . , the le v e l of foreign debt is higher than the le v e l o f pu blic debt. The reason is the follow in g one: The ov e ra ll wealth e f f e c t on private expenditures would

(Footnote continued) © The Author(s). European University Institute. Digitised version produced by the EUI Library in 2020. Available Open Access on Cadmus, European University Institute Research

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22

However, i f one relaxes the assumption according to which government bonds con stitu te a net wealth item, the economy w ill not only return to the i n i t i a l exchange r a te , but the exchange rate could even remain unchanged from the very beginning. The la tte r case is the one advanced by Barro (1974, 1981). Since there i s a f i n i t e le v e l o f government debt, any government budget has to be balanced over the longer-run. I f taxpayers discount th e ir future tax l i a b i l i t i e s in the proper way, the p o s itiv e wealth o f government bonds is netted out by the negative wealth o f future tax l i a b i l i t i e s , o r , in flow terms, the expansionary impulse o f ad ditional government expenditures is o f f s e t by the contractionary impact o f lower private expenditures as a consequence o f a lower permanent disposable income.

7

(continued)

be zero i f dF + dB = 0. Under th is con d ition , the depreciation creates an excess demand in the market fo r domestic goods; consequently, foreign debt has to r is e more in order to eq u ilib ra te the goods market.

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VI. Concluding Remarks

Exchange rate models with p e r fe ct s u b s titu ta b ility o f domestic and foreign fin a n cia l assets are p a rticu la rly w ell su ited to demonstrate th at, over the long-run, bond-financed government expenditures depreciate the domestic currency. The reason is that given the constancy o f the in te r e s t r a te , the exchange rate i s the key v a ria b le f o r e q u ilib ra tin g the rea l se c to r o f the economy— at lea st in the long-run. There are two reasons fo r t h is . The ''f i r s t re la te s to the increase in indebtedness o f the concerned country. At fin a l f u ll- s t o c k equilibrium , the current-account d e f i c i t w ill be elim inated, but the higher amount o f in te r e s t payments on foreign debt must be matched by an appropriate trade-balance surplus v ia a certa in depreciation r a te . This has been stressed in a well-known a r t i c le by Rodriguez (1979). The second reason fo r long-run currency depreciation a rises when government bonds are considered as net fin a n cia l wealth. Even i f the long-run s t a b ilit y con dition s o f a balanced government budget are met by reducing the exchange rate to i t s i n i t i a l le v e l, the higher le v e l o f government debt represents an expansionary e f f e c t on private expenditures through which temporary current-account d e f i c i t s are created. The economy ends up with a higher le v e l o f foreign

indebtedness in th is case as w e ll, and the corresponding higher in te r e st payments require a higher trade-balance surplus and thus a higher depreciation o f the currency.

Whether the re su lts o f the proposed model corroborate the fa c ts o f the evolution o f the US-dollar exchange rate sin ce the beginning o f the 1980s i s a job fo r econometric an alysis. To be sure, r e la t iv e

expansionary f i s c a l p o lic y o f the U .S., by comparison with Europe and

1 © The Author(s). European University Institute. Digitised version produced by the EUI Library in 2020. Available Open Access on Cadmus, European University Institute Research

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24

Japan, c o n stitu tes one reason fo r the appreciation o f the U.S. currency with respect to the other cu rren cies. However, over the time, a gradual depreciation o f the U.S. d o lla r must be expected according to the argu ments o f our model, since the serv ice o f the higher le v e l o f indebtedness o f the U.S. economy with respect to the r e s t o f the world has to be financed by an improvement in the American trade balance.

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References

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3. Boyer, Russel S. "P erfect F oresight, Financial P o lic ie s , and Exchange-Rate Dynamics." Canadian Journal o f Economics (February 1982), pp. 143-64.

4. Branson, William H. and Willem H. B u iter. "Monetary and F isca l P o licy With F le x ib le Exchange R ates." In J. S. Bhandari and B. H. Putnam, e d s ., Economic Interdependence and F lex ib le Exchange Rates. (Cambridge, Mass.: MIT Press, 1983), pp. 251-85.

5. C h rist, C arl. "On F isca l and Monetary P o lic ie s and the Government Budget R estra in t." American Economic Review (September 1979), pp. 539-52.

6 . Claassen, Emil. "The Keynesian and C la ssica l Determination o f the Exchange R ate." W eltw irtschaftlich es A rchiv, v o l . 199 (1983), pp. 19-35.

7. Dornbusch, Rudiger. "C apital M obility , F lex ib le Exchange Rates, and Macroeconomic Equilibrium ." In E. Claassen and P. S a lin , e d s ., Recent Issues in In ternational Monetary Economics (Amsterdam: North-Holland, 1976), pp. 261-78.

8. Dornbusch, Rudiger and Stanley F isch er. "Exchange Rates and the Current Account." American Economic Review (December 1980), pp. 960-71.

9. Frenkel, Jacob A. "Adjustment Mechanisms and the Monetary

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Approach to the Balance o f Payments: A D octrinal P e rsp e ctiv e ." In E. Claassen and P. S a lin , e d s .. Recent Issues in In ternation al Monetary Economics (Amsterdam: North-Holland, 1976), pp. 29-48.

10. Mayer, Thomas. "The Government Budget Constraint and Standard M acrotheory." Journal o f Monetary Economics (1984), pp. 371-79.

11. Mundell, Robert A. "Capital M obility and S ta b iliz a tio n P olicy Under Fixed and F le x ib le Exchange Rates." Canadian Journal o f Economics (November 1963). pp. 475-85.

12. P en a tti, Alessandro. "Expansionary F is ca l P o licy and the Exchange R ate." IMF S t a ff Papers (September 1983). pp. 542-69.

13. Rodriguez, Carlos A. "Short- and Long-Run E ffe c ts o f Monetary and F is ca l P o lic ie s Under F le x ib le Exchange Rates and P erfect Capital M o b ility ." American Economic Review (March 1979), pp. 176-82.

14. Sachs, J e ffre y and Charles Wyplosz. "La P olitiq u e Budgétaire et le Taux de Change R é e l." Annales de l'INSEE, n o. 53 (1984), pp. 68-92. © The Author(s). European University Institute. version produced by the EUI Library in 2020. Available Open Access on Cadmus, European University Institute Research Repository.

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No. X: Jacques PELKMÂNS

No. 3: Aldo RUSTICHINI

No. 9: Manfred E. STREIT

No. 10: Kumaraswamy VELUPILLAI

No. 1 1 : Kumaraswamy VELUPILLAI

No. 12 : Guglielmo CHIODI Kumaraswamy VELUPILLAI No. 22: Don PATINKIN

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No. 24: M arcello DE CECCO

No. 25: Manfred E. STREIT

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No. 34: Jean-Paul FITOUSSI

No. 35: Richard M. GOODWIN Kumaraswamy VELUPILLAI No. 46: Alessandra Venturini

No. 47: Richard M. GOODWIN No. 48: Jean-Paul FITOUSSI

Daniel SZPIRO No. 56: Bere RUSTEM

Kumaraswamy VELUPILLAI

The European Community and the Newly In du stria lized Countries

Seasonality in Eurodollar In terest Rates

Information Processing in Futures Markets. An Essay on the Adequacy o f an A bstraction

When Workers Save and In vest: Some Kaldorian Dynamics

A Neo-Cambridge Model o f Income D istrib u tion and Unemployment On Lindahl's Theory o f D istrib u tion

Paul A. Samuelson on Monetary Theory In fla tio n and Structural Change in the Euro-Dollar Market

The V iciou s/V irtuou s C irc le Debate in the '20s and the '70s

M odelling, Managing and Monitoring Futures Trading: Frontiers of A n alytical Inquiry

Economic C r is is in Eastern Europe: Prospects and Repercussions Modern Macroeconomic Theory: An Overview

Economic Systems and th eir Regulation

Is the Bargaining Theory S t i l l an E ffe c tiv e Framework o f Analysis fo r Strike Patterns in Europe? Schumpeter: The Man I Knew

P olitiq u e de l'E m ploi et Réduction de la Durée du Travail

Preferences in P o licy Optimization and Optimal Economie P olicy

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No. 60: No. 64: No. 65: No. 66: No. 67: No. 68: No. 69: No. 72: No. 75: No. 90: No. 91: No. 92: 84/103: 84/105: 84/111: 84/113: Jean-Paul FITOUSSI M arcello DE CECCO Gianpaolo ROSSINI Wolfgang GEBAUER Gerd WEINRICH Saul ESTRIN Derek C. JONES Berc RUSTEM Kumaraswamy VELUPILLAI Wolfgang GEBAUER Sheila A. CHAPMAN W ill BARTLETT Wolfgang GEBAUER Elizabeth DE GHELLINCK Paul A. GEROSKI A lexis JACQUEMIN M arcello DE CECCO Derek C. JONES Jean-Paul FITOUSSI Kumaraswamy VELUPILLAI Domenico Mario NUTI

Adjusting to Competitive Depression. The Case o f the Reduction in Working Time

Ita lia n Monetary P o licy in the 1980s Intra-Industry Trade in Two Areas: Some Aspects o f Trade Within and Outside a Custom Union

Euromarkets and Monetary Control: The Deutschmark Case

On the Theory o f E ffe c tiv e Demand Under S toch astic Rationing

The E ffe c ts o f Worker P a rticip a tion upon P roductivity in French Producer Cooperatives

On the Formalization o f P o li t ic a l Preferences: A Contribution to the Frischian Scheme

In fla tio n and In te r e st: the Fisher Theorem Revisited

Eastern Hard Currency Debt 1970- 1983. An Overview

Unemployment, M igration and Indus t r ia liz a t io n in Yugoslavia, 1958- 1982

K o n d ra tie ff's Long Waves

In ter-Indu stry and Inter-Temporal Variations in the E ffe ct o f Trade on Industry Performance

The In ternational Debt Problem in the Interwar Period

The Economic Performance o f Producer Cooperatives w ithin Command Economies Evidence fo r the Case o f Poland A Non-Linear Model o f Fluctuations in Output in a Mixed Economy

Mergers and D isequilibrium in Labour- Managed Economies 2 -© The Author(s). European University Institute. version produced by the EUI Library in 2020. Available Open Access on Cadmus, European University Institute Research Repository.

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Jan SVEJNAR the Capital and Labor Schools Compared 84/116: Reinhard JOHN On the Weak Axiom of Revealed Preference

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M u ltisectoral Models and Joint Production

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P o lic ie s in Self-Financed Producer Cooperatives

85/169: Jean JASKOLD GABSZEWICZ Asymmetric In tern a tion al Trade Paolo GARELLA © The Author(s). European University Institute. Digitised version produced by the EUI Library in 2020. Available Open Access on Cadmus, European University Institute Research

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4 -85/170: Jean JASKOLD GABSZEWICZ

Paolo GARELLA . 85/173: Berc RUSTEM

Kumaraswamy VELUPILLAI 85/178: Dwight M. JAFFEE

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Su bjective P rice Search and Price Competition

On R ation alizin g Expectations

Term Structure Intermediation by D epository In stitu tio n s

P rice and Wage Dynamics in a Simple Macroeconomic Model with Stochastic Rationing

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Gerd WEINRICH

I n s t a b ilit y and Indexation in a Labour- Managed Economy - A General Equilibrium Quantity Rationing Approach

85/187: Jesper JESPERSEN Some R eflexion s on the Longer Term Con sequences o f a Mounting Public Debt 85/188: Jean JASKOLD GABSZEWICZ Scattered S e lle r s and Ill-In form ed Buyers

Paolo GARELLA A Model o f P rice D ispersion

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Jean-Paul FITOUSSI

Wage Indexation and Macroeconomic Fluctuations

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Bibliography on Labour-Managed Firms and Employee P a rticip a tion

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Budget Deficits and the Exchange Rate

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25:Manfred E. STREIT Modelling, Managing and Monitoring

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Left-Right Political Scales: Some Expert Judgements *

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Class and Prestige Origins in the American Elite

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47:Richard A. GOODWIN Schumpeter: The Man I Knew

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Politique de l ’Emploi et Réduction de la Durée du Travail*

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Preferences in Policy Optimization and Optimal Economic Policy *

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The Sanctions Problem: International and European Perspectives *

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60:Jean-Paul FITOUSSI Adjusting to Competitive Depression. The Case of the Reduction in Working Time

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The Effects of Worker Participation upon Productivity in Fren ch Producer Cooperatives *

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On the Formalization of Political Preferences : A Contribution to the Frischian Scheme *

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Paul A. GEROSKI/ Alexis JACQUEMIN

Inter-Industry and Inter-Temporal Variations in the Effect of Trade on Industry Performance

93:Gu nther TEUBNER/ Helm ut WILLKE

Kontext und Autonomie.

Gesellschaftliche Selbststeuerung durch Reflexives Recht *

94:Wolf ga ng STREECK/ Philippe C. SCI1MITTER

Community, Market, State- and Associations. The Prospective Contribution of Interest Governance to Social Order *

95:Nigel GRIFFIN "Virtue Versus Letters": The Society

of Jesus 1550-1580 and the Export of an Idea

96:An dreas KUNZ Arbeitsbeziehungen und

Arbeitskonflikte im oeffentlichen Sektor. Deutschland und

Grossbritannien im Vergleich 1914-1924 •

97:Wolf ga ng STREECK Meo-Corporatist Industrial Relations

and the Economic Crisis in West Germany *

9 8 :Simon A. HORNER The Isle of Man and the Channel

Islands - A Study of their Status under Constitutional, International and European Law

99:Daniel ROCHE Le Monde des Ombres *

84/100:Gu nther TEUBNER After Legal Instrumentalism? *

84/101:Pa trick NERHOT Contribution aux Débats sur le Droit

Subjectif et le Droit Objectif comme Sources du Droit *

84/102:Jelle VISSER The Position of Central Confederations

in the National Union Movements

84/103:M a r c e l lo DE CECCO The International De bt Problem in the

| Inter-War Period*

8 4 / 1 0 4 :M. Rainer LEPSIUS Sociology in Germany and Austria 1918-

1945. The Emigration of the Social Sciences and its Consequences. The

(44)

8

-PUBLICATIONS OF THE EUROPEAN UNIVERSITY INSTITUTE February 1986

Development of Sociology in Germany after the Second World War, 1945-1967

84/105:Derek JONES The Economic Performances of Producer

Cooperations within Command Economies: Evidence for the Case of Poland *

84/106:P h i lippe C. SCHMITTER Neo-Corporatism and the State *

84/107:Marcos BUSER Der Einfluss der Wirtschaftsverbaende

auf Gesetzgebungsprozesse und das Vollzugswesen im Bereich des Umweltschutzes*

84/108:Frans van WAARDEN Bureaucracy around the S t a t e :Varieties

o f Collective Self-Regulation in the Dutch Dairy Industry

84/109:Ruggero RANIERI The Italian Iron and Steel Industry

and European Integration

84/110:Peter FARAGO Nachfragemacht und die kollektiven

Reaktionen der Nahrungsmittelindustrie 84/111:Jean-Paul FITOUSSI/

Kumuraswamy VELUPILLAI

A Non-Linear Model of Fluctuations in Output in a Mixed Economy *

84/112:Anna Elisabetta GALEOTTI Individualism and Political Theory

84/113:Doraenico Mario NUTI Mergers and Disequilibrium in Labour-

Managed Economies *

84/114:Saul ESTRIN/Jan SVEJNAR Explanations of Earnings in

Yugoslavia: The Capital and Labor Schools Compared

84/115:Alan CAWSON/John BALLARD A Bibliography of Corporatism

84/116:Reinhard JOHN On the Weak Axiom of Revealed

Preference Without Demand Continuity Assumptions

8 4 / 1 1 7 :Richard T.GRIFFITHS/ Frances F.B.LYNCH

The FRITALUX/FINEBEL Negotiations 1949/1950

84/118:Pierre DEHEZ Monopolistic Equilibrium and

Involuntary Unemployment *

84/119:Domenico Mario NUTI Economic and Financial Evaluation of

Investment Projects; General Principles and E.C. Procedures