External and Budget Deficits in Developing Countries

This paper documents and explains the positive comovement between external and budget deficits for several developing countries. First, the covariance estimated from post-1960 time-series data is numerically positive for each of the 24 countries and statistically significant for almost all cases. This is consistent with previous findings obtained from panel regressions. Second, the empirical covariance is close to that predicted from a tractable small open economy, overlapping generation model with heterogeneous goods. Also, the predicted covariance is induced by shocks which are closely related to internal conditions such as domestic resources and fiscal policies, and to a much lesser extent to external conditions such as the world interest rate, real exchange rate, and terms of trade. This structural analysis explaining the joint behavior of external and budget deficits sharply contrasts with earlier reduced-form studies characterizing the individual behavior of either the external deficit or budget deficit.