Twin deficits: squaring theory, evidence and common sense
Abstract"Simple accounting suggests that shocks to the government budget move the current account in the same direction, and this 'twin deficits' intuition leads many observers to call for fiscal consolidation in the US as a necessary measure to reduce the large external imbalance of this country. The response of other macroeconomic variables to budget developments, however, has important implications for 'twin deficits' and for this policy prescription. Focusing on the international transmission of fiscal policy shocks via terms of trade changes, we show that the likelihood and magnitude of twin deficits increases with the degree of openness of an economy, and decreases with the persistence of fiscal shocks. We take this insight to the data and investigate the transmission of fiscal shocks in a vector autoregression (VAR) model estimated for Australia, Canada, the UK and the US. We find that in less open countries the external impact of shocks to either government spending or budget deficits is limited, while private investment responds in line with our theoretical prediction. These results suggest that a fiscal retrenchment in the US may have a limited impact on its current external deficit." Copyright CEPR, CES, MSH, 2006.
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Bibliographic InfoArticle provided by CEPR & CES & MSH in its journal Economic Policy.
Volume (Year): 21 (2006)
Issue (Month): 48 (October)
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Other versions of this item:
- Giancarlo Corsetti & Gernot J. Müller, 2005. "Twin Deficits: Squaring Theory, Evidence and Common Sense," Economics Working Papers ECO2005/22, European University Institute.
- E62 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - Fiscal Policy
- E63 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - Comparative or Joint Analysis of Fiscal and Monetary Policy; Stabilization; Treasury Policy
- F32 - International Economics - - International Finance - - - Current Account Adjustment; Short-term Capital Movements
- F42 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - International Policy Coordination and Transmission
- H30 - Public Economics - - Fiscal Policies and Behavior of Economic Agents - - - General
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