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.