The twin deficits in the economy

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The twin deficits in the economy

References Sincethe U. To some analysts, this situation seems very reminiscent of the early s. In the earlier episode, there were significant tax rate cuts that were not matched by spending cuts, and between andthe U. Inthere were tax rate cuts that were not matched by spending cuts, and the U.

Standard economic theory would not find either situation surprising. Other things being equal, a budget deficit implies a decrease in national saving, which is the sum of private saving plus the government fiscal balance.

The First Twin: Fiscal Deficit

By definition, when national saving falls below domestic investment—that is, when the U. Of course, other things are not always equal. A number of factors may affect how much budget deficits explain current account deficits, and an extensive theoretical and empirical literature has emerged to evaluate them.

This Economic Letter reviews several of these studies. The findings suggest that the relationship between the deficits may be fairly tenuous.

An MMT View of the Twin Deficits Debate - New Economic PerspectivesNew Economic Perspectives

And in a surprising result, one study finds that—in the short run, at least—budget deficits actually have a positive effect on the current account balance. The basic theory of twin deficits A study by Baxter provides a good illustration of the standard case of the twin-ness of the budget deficit and the current account deficit.

She studies the reaction of a model economy to two fiscal policies that can lead to a worsening budget deficit: Her results show that, following the increase in the budget deficit, the current account balance deteriorates by about 0.

How does each policy lead from a budget deficit to a deterioration in the current account balance? First, consider the policy based on an increase in government spending. When the budget deficit increases, domestic residents anticipate that the government will raise taxes in the future to close the fiscal gap and pay back the accumulated debt.

To pay for the expected future increases in taxes, people will want to save and accumulate wealth, which they can do in two ways—by spending less and by boosting their income by increasing the number of hours they work. To the extent that people choose the second route and increase the hours they work, they make the capital stock more productive, which fosters more private investment.

The increase in investment partially offsets the increase in private saving, so that, overall, the current account balance deteriorates in response to the deterioration of the government fiscal balance. Next, consider the policy based on a persistent reduction in capital and labor tax rates.

After the tax rate cuts, people choose to work harder and increase the number of hours worked to take advantage of the increase in their after-tax labor income. Given the higher supply of hours worked, both output and the productivity of capital increase. But this is more than offset by a strong expansion in domestic investment that is driven by two things: As a result, the current account deteriorates.

Why the twins sometimes go their separate ways Although theory indicates that the budget deficit and the current account deficit should move together, Figure 1 shows that they followed quite divergent paths from to One possible explanation for this divergence is related to the impact of output fluctuations on budget and current account deficits.

Suppose, for example, the economy enjoys a surge in productivity that prompts an expansion in economic activity. To reap the opportunities of higher productivity, private investment increases. As investment expenditure typically reacts more strongly to the business cycle than private saving does, the current account balance deteriorates.

At the same time, the output expansion generates both an increase in tax receipts and a decline in government expenditure, due, for example, to a decline in unemployment benefits. Therefore, the budget balance improves.

Kim and Roubini used a different methodology from Baxter to do an empirical study of the effects of budget deficits on the current account that captures the impact of output fluctuations.

They found that, overall, at horizons of one to two years, output fluctuations explain most of the divergence between the budget balance and the current account.

However, more importantly, after controlling for the effects of the business cycle on the budget and current account balances and isolating the variations in the budget balance that are independent of output fluctuations, they found a surprising result: The reason for this surprising finding is that, following an increase in the budget deficit, private saving increases, as discussed before; at the same time, interest rates rise because of increased government borrowing, and the higher interest rates dampen private domestic investment.

In combination, Kim and Roubini found that the increase in private saving and the decline in domestic investment are more than enough to offset the decline in government saving in the short run and contribute to the current account improvement.Nonetheless, he said, the twin deficits aren’t good news and could push the Fed towered more aggressive monetary tightening that could bring the economic expansion to a halt.

In macroeconomics, the twin deficits hypothesis or the twin deficits phenomenon, is the proposition that there is a strong causal link between a nation's government budget balance and its . Twin deficit identity is used to refer to a nation’s current account deficits and a simultaneous fiscal deficit.

The term became widely used in the s until the s because the United States experienced the “twin” deficits during this timeframe.

Twin Deficits: Twice The Fun For The U.S. | Investopedia

Some argue the blame lies with the “twin deficits.” Here’s what ‘twin deficits’ means for the dollar and the Fed more aggressive monetary tightening that could bring the economic. Nov 14,  · The twin deficits are the residuals that accommodate the desired net saving of the domestic private sector and the ROW, respectively.

Usually the domestic non-government sectors want to accumulate dollars so the only sector left to inject dollars is the US government. Since , the U.S. has seen the emergence of twin deficits—that is, a growing budget deficit along with a growing current account deficit, which reflects increasing U.S.

borrowing from abroad. To some analysts, this situation seems very reminiscent of the early s.

The twin deficits in the economy
Twin deficits hypothesis - Wikipedia