Twin deficit or twin divergence? Fiscal policy, current account, and real exchange rate in the U.S.☆
Introduction
Questions concerning relationships between fiscal policy, the current account, and the real exchange rate are of great analytical and empirical interest. From the theoretical point of view, numerous models suggest that a fiscal expansion should lead to a worsening of the current account and an appreciation of the real exchange rate. The prime empirical example of such a relation is usually argued to be the experience of the United States with “twin deficits” in the first half of the 1980s and in the 2000s. As Figs. 1 and 2 show, a worsening of the fiscal balance (as a share of GDP) in the form of lower tax rates and higher military spending was associated with an appreciation (or a decrease) of the U.S. nominal and real exchange rates and a sharp worsening of the current account (as a share of GDP). In recent years, concerns about “twin deficits” have reemerged as a major worsening of the U.S. fiscal balance (a 6% of GDP turnaround between the large surplus of 2000 and the large deficit of 2004) was associated with a large and worsening current account balance (reaching about 5% of GDP in 2003 and further deteriorating afterwards).
The U.S. experience, however, cannot be reduced to the simple idea of repeated twin deficits and the positive relationship between the government budget balance and the real exchange rate. Most of the worsening of the fiscal deficit in the early 1980s may have been the result of the 1980–82 recession. Overall public savings started to improve from 1983 on while the current account worsened in the 1982–1986 period mainly because investment rates recovered after the slump of the 1980–82 recession. In addition, in the 1989–1991 period, the current account improved while the fiscal balance tended to worsen again. More importantly, between 1992 and 2000, the U.S. fiscal balance dramatically improved from a negative savings of 5% of GDP to a positive savings of 2.5% of GDP, but the current account worsened from − 1% of GDP to − 4.5% of GDP. Regarding the real exchange rate, the fiscal contraction and return to budget surpluses in the 1990s were associated with a real appreciation (or a decrease in the real exchange rate). Although the real dollar appreciation between 2000 and 2002 was observed in a period when budget deficits reemerged in a major way, the real exchange rate depreciated between 2002 and 2004 at a time when the budget deficit was further worsening.
These empirical facts are somewhat puzzling based on the theoretical predictions of a negative effect of fiscal expansion on the current account and the real exchange rate.2 General equilibrium endowment economy models of a small open economy with optimizing individuals and no capital account restrictions (Sachs, 1982, for a one-good model; and Frenkel and Razin, 1996, for both one and two-goods models), standard Keynesian models such as the Mundell–Fleming model and its rational expectations variants such as Dornbusch (1976), and calibrated international real business cycle models with investment such as Baxter, 1995, Kollmann, 1998, and Erceg, Guerrieri, and Gust (2005) tend to provide such predictions in most cases, although the precise effects depend on various factors such as the nature of the government budget deficit (e.g., government spending shocks or net tax shocks and the persistence of shocks), the characteristics of countries (e.g., large or small), the international asset market structure (e.g., complete markets or incomplete markets), and the specifications of the model (e.g. endogenous or fixed labor input, the existence of investment, and capital accumulation).3
The lack of strong positive correlation between government budget deficits and current account deficits may be explained by endogenous movements of the government budget and the current account. These endogenous movements are analytically and empirically crucial. During economic recessions (or booms), output falls (or rises) and the fiscal balance worsens (or improves). At the same time, the current account will improve when the fall in output leads to a fall in investment that is sharper than the fall in national savings. In particular, if there is a technology shock, as in the case of the U.S.'s New Economy and IT boom in the 1995–2000 period, there will be an investment boom that will tend to worsen the current account. At the same time, this economic boom will lead to an improvement of the fiscal balance (given automatic stabilizers on the tax and spending side). This may explain why the current account worsened in the U.S. in the 1990s while the fiscal balance was improving. Therefore, the current account can improve (or worsen) as the fiscal balance worsens (or improves). We can observe a “twin divergence,” rather than a “twin deficit,” when the main driver of the two balances is an output shock.
To evaluate these issues, this paper presents an empirical analysis of the relationship between the fiscal balance, the current account, and the real exchange rate for the U.S., for the post-Bretton Woods period of flexible exchange rates. We have examined the effects of government budget deficit shocks on the current account and the real exchange rate, and also have derived the general relationship among those variables. To identify government budget deficit shocks that control for business cycle effects, we have employed VAR (Vector Auto-Regression) models. One new and somewhat paradoxical empirical result of our study is that, contrary to most economic models, expansionary fiscal shocks or government budget deficit shocks are associated with an improvement of the current account and a depreciation of the real exchange rate. This is especially interesting because this paradoxical correlation occurs even after we control for the effects of the business cycle or output shocks that are likely to generate a “twin divergence.” That is, even “exogenous” fiscal deficit shocks seem to be associated with an improvement of the current account.
An extended analysis shows that a combination of factors, such as (1), an investment crowding out effect caused by an increase in the real interest rate and (2), a partial Ricardian movement in private savings, can account for the empirical paradox. This result may also be related to one special characteristic of the U.S. economy, namely a relatively closed large open economy. In such an economy, a fiscal expansion may lead to an increase in the real interest rate (such as the one observed in the U.S. in the early 1980s), which may in turn crowd out private investment but stimulate private savings.4 On the other hand, sticky prices seem to play an important role in the result of a real exchange rate depreciation following a government deficit shock, since a nominal exchange rate depreciation (as opposed to a change in the relative price level) mainly explains the real exchange rate depreciation.
There are other empirical studies in this area. First, there are simulation exercises that have used large scale structural models based on different versions of the Mundell–Fleming–Dornbusch model (for example, studies in Bryant et al., 1988; and Taylor, 1993) or that used calibrated dynamic stochastic general equilibrium models (for example, Baxter, 1995, Kollmann, 1998, Betts and Devereux, 2000b; and McKibbin and Sachs, 1991). However, most of the models in these studies are based on a large number of identifying restrictions implied by theory; thus, the evidence may not serve as data-oriented empirical evidence. Second, a few studies such as Ahmed, 1986, Ahmed, 1987 examined the long run relationship between government spending and the current account. They employed a static single equation method by using a long horizon dataset with annual frequency covering many exchange rate regimes. However, their results have limitations because dynamic interactions between variables are not considered and such studies do not use a sample period with an unchanged exchange rate regime. Third, a few studies have used VAR models that employ a minimum number of identifying restrictions that do not depend on specific theoretical models (for example, Clarida and Prendergast, 1999; and Rogers, 1999). However, these studies have examined the effects on the real exchange rate only with low frequency data.5 In contrast, our paper provides data-oriented empirical evidence on the effects of fiscal policy on the current account and the real exchange rate using VAR models. These models allow for dynamic interactions among variables and employ minimal identifying restrictions which do not depend on a specific theoretical model. In our work, we have employed a quarterly dataset which is the typical frequency investigated in business cycle studies. We have performed our analysis for periods of unchanged exchange rate arrangements (that is, a floating exchange rate regime only) since the effects may be different under different exchange rate regimes.
The paper is structured as follows. Section 2 provides empirical evidence based on VAR models. Section 3 presents some extended robustness tests. Finally, Section 4 concludes with a summary of our results.
Section snippets
Preliminary statistics and issues
We first present some basic properties of the data and some stylized facts that help to understand the co-movements occurring among the government budget deficit, the current account, and the real exchange rate. The current account is often called the net foreign investment. Conceptually, it is equal to the difference between national saving and investment, although the actual data contains non-negligible statistical discrepancies. Saving is further divided into private saving and government
Alternative definitions of variables, alternative identification schemes, and extended models
We examined the robustness of our main results in various dimensions. First, we examined whether our results were robust under different definitions of the government budget deficit/balance and of components of the government budget. Second, we experimented with alternative definitions of the real effective exchange rate. Third, we considered alternative identifying assumptions by changing the ordering of the variables in the system. Fourth, we considered other methods to calculate the real
Conclusion
In this paper, we have examined the effects of government deficit shocks on the current account and the real exchange rate in the United States, based on VAR models, for the flexible exchange rate regime period. The empirical model identified the government budget deficit shocks after controlling for the sources of endogenous government budget movements such as output shocks.
The empirical results suggest that the government deficit shocks improve the current account and depreciate the real
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Cited by (0)
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We thank Michele Cavallo, Fabrizio Perri, Young Chul Park, Jonas Fisher, Harald Uhlig, Kwanho Shin, Wooheon Rhee, Young Seung Jung, Dong Eun Lee, Jae Won Yu, Giancarlo Corsetti, the Co-Editor of the journal, two anonymous referees, and seminar participants at the Econometric Society North American Meeting, Korea University, Yonsei University, the Bank of Korea, the Hong Kong Institute for Monetary Research, Lingnan University, and Kyunghee University for the comments and useful discussions. The usual disclaimer applies.
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