COMOVEMENTS OF BUDGET DEFICITS, EXCHANGE RATES, AND OUTPUTS OF TRADED AND NON-TRADED GOODS

Between 1974:I-1989:II, it appears that U.S. budget deficits and real exchange rates are correlated. This paper attempts to provide a structural explanation of these comovements in government budget deficits and exchange rates. The model expands on previous works to include fiscal policy considerations in a stochastic set-up. It shows that within a simple two-country cash-in-advance constraint model, it is possible to have a positive correlation between budget deficits and exchange rates, as well as a negative correlation between exchange rates and domestic traded goods production.