Theory and Practice: Exchange Rates

The impact of fiscal policy on exchange rates:

A restrictive fiscal policy lead s to lower interest rates int he home country and, hence,  a depreciation of the currency. On the other hand, reduced government spending leads to a slower economy and lower inflation. This second effect would push the home currency to appreciate.

An expansionary monetary policy leads to higher interest rates and to appreciation of the currency on one hand, and on the other hand, to a  rise in output and inflation that act as depreciation forces. From these two effects, the appreciation effect dominates.

Below there is the graph of the Romanian leu exchange rate versus the USD and the EURO. Those familiar with the fiscal developments in the country after 2005 can easily see that theory matches practice. an empirical study on this issue would be quite relevant.

Source: www.bnr.ro