How Budget Deficit Impacts the US Dollar Exchange Rate? - Paper Example

Introduction

The US budget deficit significantly affects dollar exchange rate internationally and thus its competitiveness. The relationship between currency performance and budget deficit remains controversial amongst policymakers and economists. However, economists have developed different theories on the relationship between budget deficit and currency performance.

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In the meantime, the government of the US is not exceptional on reporting the budget deficit in various fiscal years. The budget deficit is as a result of the expenditure exceeding revenue in any given year. Meanwhile, the report shows that there is either a direct or indirect relationship between budget deficit and the currency exchange which may result in a stronger or a weaker currency. Hereby, this paper discusses how the budget deficit impacts dollar performance in terms of exchange rate.

The Impact of the US Budget Deficit on the Dollar Currency Exchange

The question of whether deficit budget impacts the US dollar performance remains unclear among policymakers and the economics. However, some economists have come up with theories on this particular issue (Su, San, and Tieng-Ming). According to conventional macroeconomic theory, the government opt to increase borrowing to finance the budget deficit and consequently the pressure on the interest rate rises resulting to an increase in the value of a particular currency ( Su et al.). In contrast, some preposition suggests that budget deficit impact on the economy is zero (Su et al.).

Moving on, Gulcan and Bilman noted that budget deficit does not impact only the currency rate but also other macroeconomic indicators. Some economics argues that the deficit has a weak relationship with currency performance while others suggest that the impact is unknown or unclear (Gulcan and Bilman). Further, Gulcan and Bilman stated that budget deficit to some extent may impact currency exchange strongly or weakly. Moreover, they note that the deficit can affect both currency performance and interest directly or indirectly. Specifically, the direct impact of the currency leads to exchange reduction while indirect impact results to increase of the currency exchange.

Accordingly, a study by Phouthanouphet and Kyophilavong visibly showcased that there is a relationship between budget deficit and the currency exchange rate. On the same line of argument, Mariano et al. noted that the deficit can lead to currency exchange rate appreciation or depreciation. However, this impact depends on two factors, the importance of relative asset and wealth effects.

The impact of the government budget deficit on the exchange rate is a factor of the action taken to compensate the same. According to Rana ,Akhtar and Rana, the government might decide to lower it's spending or raise more tax to fill the deficit. Notably, currency devaluation declines if the government reduces its expenditure on traded commodities rather than non-traded commodities (Rana et al).

Deficit reduction weakens the exchange rate of any country. Reduction in demand for the loanable fund is one of the impacts of the deficit which comes as a result of the impact on the exchange rate and interest rate (Akgay et al.). Consequently, Akgay et al. stated a mismatch between government revenue and expenditure prompt the state to borrow from the financial markets to fill the gap and therefore reducing the deficit requires little borrowing and thus lowering the interest rate and demand for loanable funds.

In the meantime, survey results by Hussain, Ali, and Saaed in their demonstrated that the impact from the relationship between currency exchange rate and the government budget deficit is a short-term and thus uncertain. Hussain et al. Study agree with AKgay et al. findings that budget deficit reduces the dollar value. Additionally, Hussain et al. argue that many economists are of the same opinion. However, some economists argue that, in the short-run, the budget deficit appreciates the value of the dollar (Hussain et al.). Moreover, they noted that a bigger deficit does not necessarily result in a stronger currency. Further, they argue that the impact of the budget deficit on aggregate demand might increase the price level and consequently diminishing the dollar value (Hussain et al.).

The Ricardian highlighted that government spending may be financed through borrowing or tax revenue. Consequently, the budget deficit has no relationship with any microeconomic variables including the currency exchange rate (Dissanayake). On the same note, the current account deficit implies the export is greater than the import and therefore such deficit needs to be financed through the capital account to prevent the currency from depreciating (Dissanayake). Arguably, (Dissanayake) note that currency exchange rate can also be influenced by the value of the government debt.

Meanwhile, depleting assets or borrowing gives rise to budget deficit (Dissanayake). Additionally, the budget can be influenced through assets and/or foreign reserve (Dissanayake). Despite the fact that the budget deficit causes the depreciating of the domestic currency, reduction of the foreign reserves and reducing the trade account deficit are two contributing factors that require consideration (Dissanayake). a study conducted in Turkey showed that there is a significant relationship between budget deficit and the currency exchange rate (Dissanayake). Additionally, the study concluded that the role of the deficit on stabilizing the real exchange rate is critical.

Table 1 shows the monthly data on US / Euro exchange and the budget surplus or deficit. The data shows insignificant relationship between the two. This implies the association between the two variables is uncertain.

Conclusion

The impact of the budget deficit on the currency exchange rate depends on the sources used to finance the budget deficit. The government can reduce on its spending when a deficit occurs or it can finance it through borrowing. Rana et al noted that cutting on the government spending devalues the currency insignificantly, especially, when done on trade goods. However, different economists hold different views on the impact of the budget deficit on the currency exchange rate. Some cite no relationship between the two while others hold that the two variables are significantly related. Further, the relationship

Budget deficit calls for different demand for funds and therefore significantly affecting, directly or indirectly, the currency exchange. Consequently reducing the budget deficit triggers reduced demand for money by the government and thus a weaker exchange rate. On the other reducing budget deficit can cause a stronger currency exchange due to the reduction of the foreign exchange premium, expected inflation, or increment of the after-tax return on asset for domestic assets. Basically, the impact of the budget deficit depends on the country under consideration.

Work Cited

Akgay, O. Cevdet, C. Emre Alper, and Suleyman Ozmucur. "Budget Deficit, Inflation and Debt Sustainability: Evidence from Turkey, 1970-2000." Inflation and Disinflation in Turkey. Routledge, 2018. 83-102

Dissanayake, D. M. S. B. "Identifying the Relationships between Budget Deficit and Selected Macroeconomic Variables: A Study of Sri Lanka During the Postliberalization Era." (2016).

FRED | St. Louis Fed". Fred.Stlouisfed.Org, 2018, https://fred.stlouisfed.org/search?st=budget+deficit. Accessed 25 Nov 2018.Gulcan, Yaprak, and Mustafa Erhan Bilman. "The effects of budget deficit reduction on exchange rate: evidence from Turkey." Dokuz Eylul University DP Series 5.07 (2005).

Hussain, Majeed Ali, and Afaf Abdull J. Saaed. "The relationship between budget deficits and macroeconomics variables in United Arab Emirates: an empirical investigation." Journal of Emerging Trends in Economics and Management Sciences 5.5 (2014): 449

Kyophilavong, Phouphet, et al. "The causality of dollarisation, interest rate and exchange rate: evidence from Laos." Global Business and Economics Review 20.1 (2018): 115-125

Mariano, Christine Niziel Q., et al. "Investigation of the Factors Affecting Real Exchange Rate in the Philippines." Review of Integrative Business and Economics Research 5.4 (2016): 171-202.

Rana Ejaz Ali Khan , Ali Abbas Akhtar and Amir Saeed Rana. Relationship between Exchange Rate and Budgetary Deficit-Empirical Evidence from Pakistan. Journal of Applied Sciences, 2 (2002): 839-842

Su, Yuli, San, and Tien-Ming Su. "The Impact of Budget Deficits on Currency Value: A Comparison of Asian and European Countries." Multinational Business Review 11.3 (2003): 94-112.