Budget Deficit Persistence and the Twin Deficits Hypothesis

This paper gauges the causal relationship between external and budget deficits by using Blanchard's overlapping generations model. This model sests the twin deficits hypothesis (i.e. there is a positive relationship between the deficits) and the Ricardian equivalence hypothesis (i.e. there is no link between the deficits). This model also implies that consumers forecast future budget deficits using (at least) the history of the two deficits. This implication is used to derive time series restrictions, which are testable for given comsumer's planning horizons. For the relevant horizon, the response of the external deficit to an increase in the budget deficit is computed. For the Canadian and the U.S. economies, the relevant horizons can be as long as 83 years. However, given the persistence of the budget deficits, these horizons produce responses that are statistically significant. These findings reconcile the mixed results obtained in previous analyses. This paper is available at ftp://crefe.dse.uqam.ca/pub/cahiers/cah31.ps The whole WP list is at http://www.er.uqam.ca/nobel/crefe/cahiers.html