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Twin deficit or twin divergence? Fiscal policy, current account, and real exchange rate in the U.S

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Author Info
Kim, Soyoung
Roubini, Nouriel

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Abstract

In spite of concerns about "twin deficits" (fiscal and the current account deficits) for the United States economy, empirical evidence suggests that "twin divergence" is a more usual feature of the historical data, i.e., when fiscal accounts worsen, the current account improves and vice versa. This paper empirically studies the effects of fiscal policy (government budget deficit shocks) on the current account and the real exchange rate, during the flexible exchange rate regime period. Based on VAR (Vector Auto-Regression) models, we identified "exogenous" fiscal policy shocks after controlling for business cycle effects on fiscal balances. In contrast to the predictions of most theoretical models, the U.S. results suggest that an expansionary fiscal policy shock, or a government budget deficit shock, improve the current account and depreciate the real exchange rate. Increases in private savings and declines in investment contribute to the current account improvement while a nominal exchange rate depreciation, as opposed to a relative price level change, is mainly responsible for the real exchange rate depreciation. The "twin divergence" of fiscal balances and current account balances is also explained by the prevalence of output shocks, i.e. output shocks -- more than fiscal shocks -- appear to drive the co-movements of the current account and the fiscal balance.

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File URL: http://www.sciencedirect.com/science/article/B6V6D-4PGY51J-1/1/eb89b51bb4a455259489cad39b5e6bb8
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Publisher Info
Article provided by Elsevier in its journal Journal of International Economics.

Volume (Year): 74 (2008)
Issue (Month): 2 (March)
Pages: 362-383
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Handle: RePEc:eee:inecon:v:74:y:2008:i:2:p:362-383

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Web page: http://www.elsevier.com/locate/inca/505552

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  1. José García-Solanes & Jesús Rodríguez López & José Luis Torres Chacón, 2007. "Demand Shocks and Trade Balance Dynamics," Working Papers 07.10, Universidad Pablo de Olavide, Department of Economics. [Downloadable!]
    Other versions:
  2. Juha Tervala, 2007. "Fiscal Policy and the Current Account in a Small Open Economy," Finnish Economic Papers, Finnish Economic Association, vol. 20(2), pages 108-120, Autumn. [Downloadable!]
  3. Christopher Erceg & Luca Guerrieri, 2005. "Expansionary Fiscal Shocks and the Trade Deficit," Computing in Economics and Finance 2005 128, Society for Computational Economics. [Downloadable!]
    Other versions:
  4. Christiane Nickel & Katja Funke, 2006. "Does Fiscal Policy Matter for the Trade Account? A Panel Cointegration Study," IMF Working Papers 06/147, International Monetary Fund. [Downloadable!]
  5. Roel Beetsma & Massimo Giuliodori & Franc Klaassen, 2005. "Trade Spillovers of Fiscal Policy in the European Union: A Panel Analysis," DNB Working Papers 052, Netherlands Central Bank, Research Department. [Downloadable!]
    Other versions:
  6. Corsetti, Giancarlo & Müller, Gernot, 2007. "Twin Deficits, Openness and the Business Cycle," CEPR Discussion Papers 6492, C.E.P.R. Discussion Papers. [Downloadable!] (restricted)
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  7. Michele Cavallo, 2005. "Government consumption expenditures and the current account," Working Paper Series 2005-03, Federal Reserve Bank of San Francisco. [Downloadable!]
  8. Ricardo J Caballero & Emmanuel Farhi & Pierre-Olivier Gourinchas, 2006. "An equilibrum model of "global imbalances" and low interest rates," BIS Working Papers 222, Bank for International Settlements. [Downloadable!]
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  9. repec:bep:mactop:v:7:y:2007:i:1:p:1529-1529 is not listed on IDEAS
  10. Bems, Rudolfs & Dedola, Luca & Smets, Frank, 2007. "US Imbalances: The Role of Technology and Policy," CEPR Discussion Papers 6110, C.E.P.R. Discussion Papers. [Downloadable!] (restricted)
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  11. Faik Koray & W. Douglas McMillin, . "Fiscal Shocks, the Trade Balance, and the Exchange Rate," Departmental Working Papers 2006-02, Department of Economics, Louisiana State University. [Downloadable!]
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