Fiscal policy and real exchange rates

Firms with higher debt relative to its size and negative cash °ows have lower value in the market. Why not the same applies to a currency value of a country? This paper investigates this question and shows empirical evidence that indeed a lower degree of government's ̄scal solvency, represented by higher debt and lower surpluses, implies an real exchange rate depreciation. Empirical results also contradict the common believed notion that only emerging economies are subject to bad ̄scal results implying currency devaluations. Pooled data regression results show that middle income economies have even lower elasticities of relative debt to real exchange rates. These results are robust to the use of controls for cited e®ects in the literature like the Balassa-Samuelson e®ect, the e®ect of government spending and the Salter e®ect. The paper also proposes a simple model to explain the empirical evidence found. In the model, the real exchange rate deviates from the PPP parity because at time t agents expect a di®erent rate of in°ation for each currency in the next day.