The Effects of Public Spending Shocks on Trade Balances and Budget Deficits in the European Union

We investigate the consequences of an increase in public spending for trade balances and budget deficits in the European Union, using a panel vector auto-regression approach. Whereas the literature tends to treat the trade balance/GDP ratio as a single variable, we include exports and imports as separate variables. This allows us to track in more detail the sources of trade balance movements. Further, we use annual rather than quarterly data. This facilitates the interpretation of the shocks and reduces potential anticipation effects of fiscal policy changes. However, the identification assumptions become stronger, and we extensively check their validity. According to our baseline estimate, a 1% GDP increase in public spending produces a 1.2% on impact rise and a 1.6% peak rise in GDP. Rising imports and falling exports are responsible for a fall of the trade balance by 0.5% of GDP on impact and a peak fall of 0.8%. In addition, the spending increase produces a 0.7% impact (and peak) budget deficit, thereby pointing to the potential relevance of the twin deficits hypothesis for the European Union. (JEL: E62, H60) (c) 2008 by the European Economic Association.