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

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