Fiscal financing decisions and exchange rate variability

Abstract

One of the perceived benefits of a flexible exchange rate system is the insulation of the domestic economy from foreign shocks, and the potential for independent policy actions. In view of the considerable uncertainty, which pervades appropriate specification of the relevant theoretical models, the empirical analysis of this paper adopts the vector autoregressive approach. Using quarterly data over the period 1975(2)‐1995(2), models are estimated which test the effect on exchange rates of fiscal variables for seven countries (Australia, Canada, Britain, France, Germany, Italy and the USA). In testing the exchange rate response to a bond financed fiscal expansion, a tax financed fiscal expansion and to a swap of taxes for debt with no change in the level of government expenditure, the results for the seven countries over the recent float are mixed because the impulse response functions to the shocks do not have the same pattern in every country.