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Twin Deficits, Openness and the Business Cycle

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  • Corsetti, Giancarlo
  • Müller, Gernot

Abstract

In this paper, we study the co-movement of the government budget balance and the trade balance at business cycle frequencies. In a sample of 10 OECD countries we find that the correlation of the two time series is negative, but less so in more open economies. Moreover, for the US the cross-correlation function is S-shaped. We analyze these regularities taking the perspective of international business cycle theory. First, we show that a standard model delivers predictions broadly in line with the evidence. Second, we show that conditional on spending shocks the model predicts a perfect correlation of the budget balance and the trade balance. Yet, the effect of spending shocks on the trade balance is contained if an economy is not very open to trade.

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Bibliographic Info

Paper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number 6492.

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Date of creation: Sep 2007
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Handle: RePEc:cpr:ceprdp:6492

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Keywords: Business Cycle; Fiscal Policy; Openness; Twin Deficits;

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References

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  1. Chari, V V & Kehoe, Patrick J & McGrattan, Ellen R, 2002. "Can Sticky Price Models Generate Volatile and Persistent Real Exchange Rates?," Review of Economic Studies, Wiley Blackwell, vol. 69(3), pages 533-63, July.
  2. David K. Backus & Patrick J. Kehoe & Finn E. Kydland, 1992. "Dynamics of the trade balance and the terms of trade: the S-curve," Working Paper 9211, Federal Reserve Bank of Cleveland.
  3. Giancarlo Corsetti & Gernot J. Müller, 2008. "Twin Deficits, Openness, and the Business Cycle," Journal of the European Economic Association, MIT Press, vol. 6(2-3), pages 404-413, 04-05.
  4. Gernot Mueller & Giancarlo Corsetti, 2007. "International Dimensions of Fiscal Policy Transmission," 2007 Meeting Papers 726, Society for Economic Dynamics.
  5. Heathcote, Jonathan & Perri, Fabrizio, 2002. "Financial autarky and international business cycles," Journal of Monetary Economics, Elsevier, vol. 49(3), pages 601-627, April.
  6. Giancarlo Corsetti & Gernot J. Müller, 2005. "Twin Deficits: Squaring Theory, Evidence and Common Sense," Economics Working Papers ECO2005/22, European University Institute.
  7. Ravn, Morten O., 1997. "International business cycles in theory and in practice," Journal of International Money and Finance, Elsevier, vol. 16(2), pages 255-283, April.
  8. Kim, Soyoung & Roubini, Nouriel, 2008. "Twin deficit or twin divergence? Fiscal policy, current account, and real exchange rate in the U.S," Journal of International Economics, Elsevier, vol. 74(2), pages 362-383, March.
  9. Christopher J. Erceg & Luca Guerrieri & Christopher Gust, 2005. "Expansionary Fiscal Shocks and the US Trade Deficit," International Finance, Wiley Blackwell, vol. 8(3), pages 363-397, December.
  10. David Backus & Espen Henriksen & Frederic Lambert & Christopher Telmer, 2009. "Current Account Fact and Fiction," NBER Working Papers 15525, National Bureau of Economic Research, Inc.
  11. Roel Beetsma & Massimo Giuliodori & Franc Klaassen, 2008. "The Effects of Public Spending Shocks on Trade Balances and Budget Deficits in the European Union," Journal of the European Economic Association, MIT Press, vol. 6(2-3), pages 414-423, 04-05.
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Cited by:
  1. James Feyrer & Jay C. Shambaugh, 2009. "Global Savings and Global Investment: The Transmission of Identified Fiscal Shocks," NBER Working Papers 15113, National Bureau of Economic Research, Inc.
  2. Fujiwara, Ippei & Ueda, Kozo, 2013. "The fiscal multiplier and spillover in a global liquidity trap," Journal of Economic Dynamics and Control, Elsevier, vol. 37(7), pages 1264-1283.
  3. Athanasios O. Tagkalakis, 2013. "Discretionary fiscal policy and economic activity in Greece," Working Papers 169, Bank of Greece.
  4. Fratzscher, Marcel & Juvenal, Luciana & Sarno, Lucio, 2009. "Asset Prices, Exchange Rates and the Current Account," CEPR Discussion Papers 7614, C.E.P.R. Discussion Papers.
  5. Enders, Zeno & Müller, Gernot J. & Scholl, Almuth, 2011. "How do fiscal and technology shocks affect real exchange rates?: New evidence for the United States," Journal of International Economics, Elsevier, vol. 83(1), pages 53-69, January.
  6. Martin Boileau & Michel Normandin, 2012. "Do tax cuts generate twin deficits? A multi-country analysis," Canadian Journal of Economics, Canadian Economics Association, vol. 45(4), pages 1667-1699, November.
  7. Christopher Gust & Sylvain Leduc & Nathan Sheets, 2008. "The adjustment of global external balances: does partial exchange rate pass-through to trade prices matter?," Working Paper Series 2008-16, Federal Reserve Bank of San Francisco.
  8. Philip Lane, 2010. "Some Lessons for Fiscal Policy from the Financial Crisis," The Institute for International Integration Studies Discussion Paper Series iiisdp334, IIIS.
  9. Giancarlo Corsetti & Gernot J. Mueller, 2007. "Twin Deficits, Openness and the Business Cycle," Economics Working Papers ECO2007/20, European University Institute.
  10. Horag Choi & Nelson C. Mark, 2009. "Trending Current Accounts," NBER Working Papers 15244, National Bureau of Economic Research, Inc.
  11. Lane, Philip R., 2009. "A New Fiscal Strategy for Ireland," The Economic and Social Review, Economic and Social Studies, vol. 40(2), pages 233–253.

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