Fiscal Rules and Twin Deficits: The Link between Fiscal and External Balances

Abstract

This paper investigates the relationship between countries' fiscal balances and current accounts with an emphasis on the role of fiscal rules. The direct effect of fiscal policy on the current account via aggregate (import) demand is potentially amplified by indirect effects, materialising through interest rate effects and intergenerational transfers that reduce savings. On the other hand, the implied positive relation between fiscal and external balances is potentially attenuated by offsetting changes in savings through Ricardian equivalence considerations. We expect this attenuation effect to be stronger in countries with more stringent fiscal rules and test this hypothesis using a panel of 73 countries over the period 1985–2012. As with previous studies, we find a positive effect of fiscal balances on the current account, supporting the twin deficit hypothesis. However, the effect of fiscal balances on the current account depends on the stringency of fiscal (budget balance or debt) rules in place; it is reduced by one‐third on average and virtually eliminated for countries with the most stringent fiscal rules.

Twin deficit hypothesis and reverse causality: a case study of China

“…We further applied Granger causality test the results concluded that there is a strong inverse causal relationship between budget deficit and current account deficit meaning that Keynesian preposition is more plausible than Ricardian Equivalence theorem in the light of above data. Our results are consistent with Banday and Aneja, (2019); Banday and Aneja, (2016); Ganchev, 2010; Bhat and Sharma (2018); Badinger et al (2017), and Afonso et al (2018).…”

“…Garg and Prabheesh (2017) investigate the twin deficit for India by using ARDL model and confirm the twin deficit hypothesis. Badinger et al (2017) investigated the role of fiscal rules in the relationship between fiscal and external balances for 73 countries over the period of 1985-2012. Their results confirm the twin deficits hypothesis.…”

Twin Deficits Revisited: A Role for Fiscal Institutions?

“…4 In theory, in the case of perfect capital mobility, with capital flowing among countries to equalise the yield to investors, the current account deficit could increase by exactly the same amount as the budget deficit. 5 On the other hand, while a fiscal expansion can drive the current account into deficit, the resulting eventual higher interest rates can push the capital account into surplus. Therefore, the final effect on foreign reserves accumulation is less clear, and depends on the relative sensitivity of international capital flows and on the responsiveness of imports to income.…”

“…Dornbusch (1976) showed that the interest rate is a key factor between the adjustments of the domestic economy and of the current account 5. With perfect capital mobility, fiscal policy cannot restore the internal balance(Mundell, 1963).…”

Composition of trade flows and the effectiveness of fiscal devaluation

“…The same holds true for GDP growth, but a difference might arise in the trade balance of capital goods, which can deteriorate with higher GDP growth rates in a different manner than the consumer goods’ balance, especially if GDP growth is more export driven. While the related literature has mostly found positive relationships between fiscal and external balances (see, e.g., Badinger, Fichet de Clairfontaine, & Reuter, ; for recent empirical evidence), the effects of fiscal expansion on trade balances can vary across product categories, depending on the composition of government spending, for example whether it spends relatively more on capital than on consumer goods. There might also be differences in tastes or in consumption and saving patterns depending on the relative development level of single countries, which is why we control for real GDP per capita in one of our specifications.…”