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Twin Deficit or Twin Divergence? Fiscal Policy, Current Account, and Real Exchange Rate in the US

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Soyoung Kim
Nouriel Roubini

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Abstract

In spite of the concerns about "twin deficits" (fiscal and current account deficits) for the U.S., empirical evidence suggests that “twin divergence” is a more regular feature of the data: when the fiscal accounts worsen, the current account improves and vice versa. We thus study empirically the effects of fiscal policy (government budget deficit shocks) on the current account and the real exchange rate mostly for the flexible exchange rate regime period. Based on VAR models, “exogenous” fiscal policy shocks are identified after controlling the business cycle effects on fiscal balances. In contrast to the predictions of the most theoretical models, the results suggest that an expansionary fiscal policy shock (or a government budget deficit shock) improves the current account and depreciates the real exchange rate for the flexible exchange rate regime period. The private saving rises and the investment falls contribute to the current account improvement while the nominal exchange rate depreciation (as opposed to the price level changes) is mainly responsible for the real exchange rate appreciation. The twin divergence of fiscal balances and current account balances is also explained by the prevalence of output shocks; output shocks, more than fiscal shocks, appear to drive the current account movements and its comovements with the fiscal balance

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Publisher Info
Paper provided by Econometric Society in its series Econometric Society 2004 North American Winter Meetings with number 271.

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Date of creation: 11 Aug 2004
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Handle: RePEc:ecm:nawm04:271

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Related research
Keywords: Real Exchange Rate Current Account Government Budget Deficit Fiscal Policy VAR

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Find related papers by JEL classification:
F41 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - Open Economy Macroeconomics

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  1. Roel Beetsma & Massimo Giuliodori & Franc Klaassen, 2005. "Trade Spillovers of Fiscal Policy in the European Union: A Panel Analysis," EUI-RSCAS Working Papers 31, European University Institute (EUI), Robert Schuman Centre of Advanced Studies (RSCAS). [Downloadable!]
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  2. 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:
  3. 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!]
  4. Michele Cavallo, 2005. "Government consumption expenditures and the current account," Working Paper Series 2005-03, Federal Reserve Bank of San Francisco. [Downloadable!]
  5. 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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  6. Egil Matsen & Tommy Sveen & Ragnar Torvik, 2007. "Savers, Spenders and Fiscal Policy in a Small Open Economy," Topics in Macroeconomics, Berkeley Electronic Press, vol. 7(1), pages 1529-1529. [Downloadable!] (restricted)
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  7. Giancarlo Corsetti & Gernot J. Mueller, 2007. "Twin Deficits, Openness and the Business Cycle," Economics Working Papers ECO2007/20, European University Institute. [Downloadable!]
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  8. 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!]
    Other versions:
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