The external effects of public sector deficits

Abstract

This paper develops a two equation model for measuring how public sector deficits - and the way that they are financed - affect the real exchange rate, the trade balance, the current account and the level of external indebtedness. One equation relates the real exchange rate to the trade surplus and the other describes the trade surplus as a function of structural parameters, the fiscal deficit, and the stock of foreign assets. To make the model dynamic, one must allow for the fact that the level of foreign assets - one determinant of the trade surplus and current account - changes over time. The trade surplus, plus foreign internest earned, determines the evolution over time of the stock of foreign assets. Using this model, the paper makes the following conclusions. The level and composition of government spending affects the real exchange rate because of the effect of spending on nontraded goods. Changes in the trade balance are also bound to affect the real exchange rate. How much depends on how much expenditure must be switched to make the trade balance compatible with the change in aggregate spending.Economic Theory&Research,Economic Stabilization,Environmental Economics&Policies,Macroeconomic Management,Public Sector Economics&Finance