The Government Deficit and the Exchange Rate

As government deficit spending declines, the question of its impact on the exchange rate is clearly relevant. Recent empirical work has been contradictory. This paper presents a two-country cash-in-advance model to calculate explicitly the long- and short-term effects of government deficit spending on the exchange rate. It is shown that increases in deficit spending result in a short-term appreciation of the currency. The currency will eventually depreciate, to what degree and for how long depending on the method used to finance the deficit.