Exchange Rate Regime Preferences and Budget Deficits in Open Economies: Evidence From FGLS and PCSE Estimation Methods

Introduction

Fiscal policy is an essential tool in managing the economy. The effects of taxation, government spending, and borrowing on growth patterns are often reflected in the literature on developed and developing countries (Easterly & Rebelo, 1993). To successfully manage fiscal policy, governments strive to collect taxes at a level that can cover government spending and balance the budget. However, modern fiscal theories suggest that budget deficits can be tolerated to support economic growth, while a balanced budget is rarely achieved. In this regard, there is extensive literature on the results and determinants of budget deficits. Determinants of the budget deficit differ depending on economic approaches. Various studies have been conducted within the framework of these approaches. A comprehensive and recent literature discussion on budget deficits’ determinants can be found in Mawejje and Odhiambo (2020).

The literature on the budget deficit has been shaped according to economic views. For example, the classical approach to fiscal deficits emphasizes the inflationary effects that fiscal deficits can create by advocating the decline in the state's role in the economy. On the other hand, Keynesian economists reject the classics' arguments and advocate for governments to play a larger role in the economy. In their opinion, governments should intervene in the economy through tax, spending, and borrowing policies. These measures will inevitably lead to an increase in the budget deficit. It is emphasized that the implementation of policies stimulating the budget deficit to combat the deficit in demand in the economy will ensure economic growth through the multiplier effect (Bernheim, 1989). From a Keynesian perspective, budget deficits increase the current account deficit by increasing national income. This interconnection leads to a situation known in the literature as the twin deficit hypothesis. In the case of a flexible exchange rate in an open economy, an increase in the demand for money, resulting from increased income levels due to expanded government spending, will lead to higher interest rates. This situation provides capital inflow to the economy, leading to the national currency's appreciation and, indirectly, to a current account deficit. In other words, a current account deficit occurs along with a budget deficit, that is, a twin deficit (Kim & Roubini, 2008; Tobin, 1984). However, there are opposite results in the literature regarding this hypothesis. For example, Kim and Roubini (2008) analysed the relationship between the flexible exchange rate regime (ERR), the budget deficit, and the USA's current account deficit under the twin deficit hypothesis. Their findings indicate that the budget deficits arising from the expansionary public expenditures positively affect the current account balance and cause a loss in the value of the US exchange rate. On the other hand, Bahmani-Oskooee (1995) found evidence to support the twin deficit hypothesis, according to which budget and trade deficits are related.

According to the Ricardian equivalence hypothesis, taxes are deferred to the next generation by borrowing due to the budget deficit arising from tax cuts. In other words, taxes that are reduced today will be increased even more in the future. Individuals increase their savings because they know that their tax burden will increase in the future. For this reason, budget deficits caused by tax cuts do not have a real effect on variables such as the current account deficit, as stated in the twin deficit hypothesis (Barro, 1974, 1989). From a monetarism point of view, it is stated that the seigniorage used to finance budget deficits will cause inflation. Although, monetarists have seen inflation as a monetary situation since Friedman (1968, 1989). According to Sargent and Wallace (1981), the relationship between fiscal and monetary policies is explained with the inter-temporal budget constraint. This approach states that the financing of long-term chronic budget deficits through domestic borrowing will have a more inflationary effect than monetary financing in the long run. Tight monetary policy will reduce inflation in the current period and cause more inflation in the future. Therefore, chronic budget deficits cannot be sustained in the long run.