Dynamics of budget and trade deficits: evidence form four countries.

Author:Hwang, Jae-Kwang

    One of the most interesting and controversial issues of the early 1980s was the cause of the rapid appreciation of the dollar on the foreign exchange market. One explanation for the rapid appreciation of the dollar focuses on the large U.S. budget deficits. Any increase in the U.S. budget deficit may raise U.S. real interest rates. In turn, high U.S. interest rates may crowd out private domestic investment spending. However, funds may be attracted from the rest of the world to forestall such crowding out. As the U.S. capital account surplus rises, the real exchange rate of the dollar rises.

    The effective exchange rate of the dollar appreciated over 50 percent in the early to middle 1980s. At the same time, the U.S. budget deficit increased from $49 billion to $160 billion. It is widely believed that the large deficit made a substantial contribution to the appreciation of the dollar. As a result, the U.S. products became less competitive in the world market, the U.S. trade deficits increased. It was called "twin deficits."

    Again, global current account imbalances are increasing rather than decreasing in 2000s. The trade deficit was about $714 billion in 2005 and rose to $762 billion in 2006, and it is likely to grow more in the future. At the same time, the US is running a large budget deficit that is growing. Thus, the US appears to have a twin fiscal and current account deficit, then it might spark renewed debate over the twin-deficit hypothesis.

    Empirical works [Marinheiro (2008), Baharumshah and Lau (2007), Bartolini and Lahiri (2006), Corsetti and Muller (2006), Salvatore (2006), Kim and Kim (2006), Baharumshah, Lau and Khalid (2006), Papadogonas and Stournaras (2006), Saleh (2006), Makin (2004), Leachman and Francis (2002), and Kasibhatla, Johnson, Malindretos, and Arize (2001)] show that these two deficits are closely related and that budget deficit causes the trade deficit.

    On the other hand, Kim and Roubini (2008) show that an expansionary fiscal policy shock improves the current account and depreciate the real exchange rate. It means that when fiscal accounts worsen, the current improves and vice versa. Kouassi, Mougoue, and Kymn (2004) show that the evidence of causality between the twin deficits are less persuasive for developed countries.

    The objective of this paper is to investigate whether there is long-run as well as short-run relationship between budget deficit and trade deficit by using quarterly data over the period of 1975:1-2005:4 from the U.S., the United Kingdom, France, and Canada. This paper implements a cointegration technique to detect a stable long-run relationship between two variables and then uses an error correction model to detect dynamic short-run relationship between two variables. Empirical work based on four countries would help figure out the medium to long-term sustainability, if there is any, between budget deficit and trade deficit. The second section discusses two controversial theoretical positions. The third section presents methodology and empirical results. The final section concludes.


    This paper considers two controversial theories, which are respectively conventional macroeconomic theory and the Ricardian equivalence proposition. Conventional macroeconomic theory says that the large domestic budget deficit causes the appreciation of the home currency.

    According to the conventional macroeconomic theory, large government deficits crowd out real investment by raising interest rates. Increases in the budget deficits raise real long-term interest rates and these higher rates attracted funds to the United States. In the IS-LM framework, suppose that there is an increase in the government spending. As a result, this causes the IS curve to shift to the right and interest rate as well as output increases. Under the assumption of high capital mobility (or perfect capital mobility) and the floating exchange rates, higher interest rate induces foreign investors to buy the U.S. assets. Higher income makes domestic people to buy more foreign goods so less exports.

    The Ricardian proposition states that when government spending is constant, higher deficits do not raise interest rates because taxpayers save more to meet future tax liabilities thus offsetting higher government borrowing. However, transitory increases in government spending will raise interest rates regardless of whether the increase is tax or debt financed. Those economists who believe that deficits do not raise real interest rates because they induce an equal offsetting rise in private savings reject the role...

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