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Understanding the twin deficits: new approaches, new results

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  • Michele Cavallo

Abstract

Since 2002, the U.S. has seen the emergence of twin deficits—that is, a growing budget deficit along with a growing current account deficit, which reflects increasing U.S. borrowing from abroad. To some analysts, this situation seems very reminiscent of the early 1980s. In the earlier episode, there were significant tax rate cuts that were not matched by spending cuts, and between 1981 and 1986, the U.S. budget deficit went from 2.5% of GDP to about 5% of GDP and the current account went from being roughly in balance to a deficit of 3.3% of GDP. In 2001, there were tax rate cuts that were not matched by spending cuts, and the U.S. budget went from a surplus to a deficit that reached 3.5% of GDP in 2004; the current account deficit also soared, rising from 3.8% of GDP in 2001 to 5.7% in 2004. ; A number of factors may affect how much budget deficits explain current account deficits, and an extensive theoretical and empirical literature has emerged to evaluate them. This Economic Letter reviews several of these studies. The findings suggest that the relationship between the deficits may be fairly tenuous. And in a surprising result, one study finds that—in the short run, at least—budget deficits actually have a positive effect on the current account balance.

Suggested Citation

  • Michele Cavallo, 2005. "Understanding the twin deficits: new approaches, new results," FRBSF Economic Letter, Federal Reserve Bank of San Francisco, issue jul22.
  • Handle: RePEc:fip:fedfel:y:2005:i:jul22:n:2005-16
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    References listed on IDEAS

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    1. Baxter, Marianne, 1995. "International trade and business cycles," Handbook of International Economics,in: G. M. Grossman & K. Rogoff (ed.), Handbook of International Economics, edition 1, volume 3, chapter 35, pages 1801-1864 Elsevier.
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    Cited by:

    1. Henryk Gurgul & Lukasz Lach, 2012. "Two deficits and economic growth: case of CEE countries in transition," Managerial Economics, AGH University of Science and Technology, Faculty of Management, vol. 12, pages 79-108.
    2. 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.
    3. Holmes, Mark J., 2011. "Threshold cointegration and the short-run dynamics of twin deficit behaviour," Research in Economics, Elsevier, vol. 65(3), pages 271-277, September.
    4. Yoichi Matsubayashi, 2010. "Budget Deficits and Current Account in Japan and the U.S.: An Empirical Evidence on the Twin Deficits Hypothesis," Discussion Papers 1010, Graduate School of Economics, Kobe University.
    5. Döhrn, Roland & Brüstle, Alena & Middendorf, Torge & Schmidt, Torsten, 2005. "Die wirtschaftliche Entwicklung im Ausland: Weltwirtschaft trotzt Energieverteuerung," RWI Konjunkturberichte, RWI - Leibniz-Institut für Wirtschaftsforschung, vol. 56(1), pages 3-22.
    6. Nizar, Muhammad Afdi, 2013. "Pengaruh Defisit Anggaran Terhadap Defisit Transaksi Berjalan Di Indonesia
      [The Effect of Budget Deficit on Current Accounts Deficit in Indonesia]
      ," MPRA Paper 65609, University Library of Munich, Germany.
    7. Tuck Cheong Tang & Evan Lau, 2009. "General Equilibrium Perception on Twin Deficits Hypothesis: An Empirical Evidence for the U.S," Monash Economics Working Papers 09-09, Monash University, Department of Economics.

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    Keywords

    Budget deficits ; Fiscal policy;

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