The impact of budget deficit shocks on the real exchange rate

The effect of budget deficit shocks on the real exchange rates has generated empirical controversy since the early 1980s. Studies attempting to quantify the effects of budget deficit shocks on the real exchange rate using the U.S. data produce conflicting results: some support that positive budget deficit shocks lead to real exchange rate appreciation, some find an opposite effect, and others conclude no such effects at all. This dissertation attempts to reconcile the conflicting results by first evaluating three representative models: Feldstein's reduced-form model, Abell's six-variable Vector Autoregression (VAR) model and Karras's Structural VAR model with contemporaneous restrictions. The first two of these models are found to have shortcomings and are corrected. These three models (two modified and one original) are then used to replicate previous work which is extended through 1999. All models are shown to generate supporting evidence for the following conclusion: in the long-run, budget deficit shocks have either no effects or negative effects (if any) on the real exchange rates. However, after replacing the contemporaneous restrictions with long-run restrictions, an approach which receives stronger theoretical support, the deficit shocks do have positive and significant effects on the real exchange rate.