
INTRODUCTION
Deficits in U.S. federal budget and current account have occurred in the past three decades except in the late 1990s under the Clinton administration with budget surplus. Standard explanation of the twin deficits phenomenon (Abel, Bernanke, & Crushore, 2011) states that government budget deficit caused by imbalance in spending and tax revenue results in negative government saving. Shortage in national saving provides insufficient funds for domestic investment. To eradicate this gap the country will rely on foreign borrowing which leads to current account deficit. However, current literature on the twin deficits suggests no or low correlation between the two (Cavallo, 2005). The implication may point to independence between fiscal and trade policies. By March 2011, total public debt has mounted to $14.27 trillion, of which 9 percent is owned by foreigners. After much wresting, Congress agreed to raise the borrowing ceiling by $1 trillion in 2011. The breadth and depth of this issue warrants a general equilibrium approach involving all sectors of the economy: governmental policy on spending, tax rates and national debt; trade policy on exchange rate; monetary policy of supply of money and interest rate; investment from business community and spending by consumers/producers. A rational expectations component enables the introduction of uncertainty in policy making.
The purpose of this paper is to construct a dynamic linear general equilibrium model to investigate the twin deficit issue and to empirically compare with several key variables of the U.S. economy. Specifically we are looking into the effect of volatility of current account on fiscal and monetary performance, and terms of trade aspects in the U.S. This paper contributes to the literature in three ways, first it may shed light on the twin deficits issue in a general equilibrium approach; second it provides new optimal path for parameter estimates on the effect of volatility in current account balance on policy actions by the monetary authority; and third it provides insight of the relationship between the volatility in the current account and terms of trade. This paper is organized in the following order, section two gives a brief discussion of relevant literature, section three describes model used and sources of data. Results are reported in section four, followed by analysis in section five. Section six concludes.

LITERATURE REVIEW
In 1991 Rock (1991) summarizes the nature of the twin deficits debates in the U.S. but it has been experienced by other countries such as Iran. Baxter (1995) in her twocountry stochastic growth general equilibrium model for business cycles includes a section on the twin deficits. It demonstrates that government deficit based on excessive spending or shortage of revenue from tax cuts will lead to current account deterioration. On the other hand, Kim and Roubini (2008) claim that the U.S. experience is more complex and provide a contrary view that increases in budget deficits reduce the current account deficit in 1989 to 1991.
Tornell and Lane (1994) discuss the nature of the relationship between the current account and fiscal policy by terms of trade improvements. Using panel data of twentythree countries including Korea their regression results suggest that the structure of the fiscal process is critical in determining outcomes. Duncan (2003) revisits the HarbergerLaursenMetzler Effect (HLME) by examining the Chilean terms of trade and current account records. His dynamic stochastic framework in maximizing a representative agent's indirect utility function uses three transmission channels, one is through government spending. The intertemporal elasticity of substitution affecting the extent of the HLME is moderately low for Chile in the span of 1986 to 2002. Belaygorod and Dueker (2005) using dynamic stochastic general equilibrium models examine the relationship between monetary policy and inflation targeting. Their monetary policy stems from interest rate instead of quantity of money which is different from this paper. The intent of this paper is not to estimate the intertemporal elasticity of substitution of a utility function but to examine how volatility in current account balance affects terms of trade.

MODEL AND DATA
3.1. MODEL
In this paper we adopt a dynamic linear equilibrium system consisting consumers, business firms, government, monetary authority, and foreign trade sectors. The main focus is on how the U.S. fiscal and monetary authorities react to the changes in volatility in the current account balance at the steady state of the economy. We also investigate the responses of terms of trade pertaining to such shocks. We assume the typical consumer is maximizing his intertemporal utility subject to budget constraint which includes income and revenue from holding bonds issued by the government. To maximize infinitehorizon utility the Euler equation can be derived. The business sector conducts investment every period, which in this study is limited to capital inflow by foreign direct investment. This type of the investment is more sensitive to domestic interest rate, business tax rate, and foreign exchange rate.
The Treasury Department of the federal government is responsible for budget surplus/deficit and the Federal Reserve System for money supply and interest rate. The Treasury finances federal public services subject to tax revenues and bonds. In providing such services federal budget deficit may be connected to the private sectors trading when bonds are exported. Therefore, we include both the lagged volatility of the current account term and the expectations term in the government fiscal policy consideration. The international trade sector is represented by terms of trade which determinants include the volatility of current account balance, expected consumption, and exchange rate.
In recursive dynamic programming models, the Bellman equation can be used in infinite horizon problems by breaking a big longhorizon question into a twohorizon smaller problem (Sargent, 1987; Ljungqvist & Sargent, 2004). Trehan and Walsh (1991) demonstrate that twoperiod is sufficient to model all future periods in longrun balanced budget. Consequently we model the endogenous variables (government budget deficit, money supply, capital stock, and terms of trade) as functions of its lagged and exogenous variables (consumption, interest rate, business tax rate, public debt, exchange rate, and volatility of current account balance).
The dynamic linear system of equations is specified in the following: 1. The current account balance volatility variable
[(BCAV).sub.t] = [ (1/8) [[summation].sup.8.sub.i=1] ([BCA.sub.ti]  [[bar.BCAt]).sup.2]].sup.1/2] (1a)
[(BCAV).sub.t] = [[PHI].sub.0] + [[PHI].sub.1] [(BCAV).sub.t1] + [[epsilon].sub.1,t] (1b)
The concept of volatility of the current account balance follows from McMillin's (1991) definition on money growth volatility. We use a standard deviation of rolling eightperiod current account balance for this variable. A simple notion of current account balance follows from Obstfeld and Rogoff (1996) listed in appendix.

The Euler equation of an aggregate consumption function in logarithmic form:
[E.sub.t][ln[C.sub.t+1]] = [[beta].sub.1], In[C.sub.t] + ln[(1 + r).sub.t] (2)
Where, InC is ,he natural log of aggregate consumption, considered to be exogenous. In(1+r) is a function of real interest, rate (Obstfeld and Rogoff, 1996). Details of the macro dynamic system involving consumer/producer, capital goods, the fiscal sector and the trade sector are presented in appendix. Equation 2 presents ,he Euler equation in the system derived from the consumer/producer's maximization of utility function subject to budget constraint. Here [E.sub.t][In[C.sub.t+1]] is the rational expectations term for aggregate consumption expenditure one period forward.

A Bellman's equation for business investment:
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Volatility in U.S. current account and government policy.
Author:  Chen, David Y. 
Position:  Report 
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