Commentary
The slump of the Pound Sterling last week was said to be a reaction to the UK’s new Prime Minister Liz Truss’ tax cut proposal. An exchange rate represents the purchasing power of money. An excess of it results in depreciation. A government planning to finance its budget deficits by printing money will be bound to devalue a currency. This is the story behind the Sterling crisis. Simple as it appears, however, there are technicalities in operationalizing such a hypothesis. Moreover, there are also other factors beyond the fiscal sector that affects the exchange rate.
Fiscal deficits are common everywhere, especially in advanced economies. While the UK has fiscal deficits, the U.S. has that as well. Thus, the correct explanatory variable should be the difference or ratio between the government budget deficits of the U.S. and the UK. The standard normalized presentation of it is the budget deficits expressed in terms of GDP. This has the advantage that both deficits and GDP are in local currency so the ratio has no unit. Accordingly, the difference between UK’s and U.S.’s deficits-to-GDP can be obtained easily….