Revisiting the case of U.S. deficits.

Abstract

In this study we examine the case of the Twin Deficits for the United States. By re-examining the results of already existing empirical work, which has up to now, produced mixed results, we attempt to determine the relationship between the current account and the government budget deficits for the period following Bretton Woods. To this end, we employed a recursive VAR, through which we induced fiscal policy shocks to our model, in order to observe the response of the current account and the real exchange rate. Our findings suggest that an increase in the government budget deficit, leads to an improvement of the current account and an appreciation of the real exchange rate. The dynamics behind these mixed results stem mostly from the increase in private savings and a decrease in private investment. As a response to an expansionary fiscal policy shock, a partial Ricardian behavior, as well as a crowding out effect is observed.