Budget deficit persistence and the twin deficits hypothesis

Abstract

This paper gauges the twin deficits hypothesis, i.e. a positive causal relationship between the external and budget deficits. This relationship is measured by the responses of the external deficit to changes in the budget deficit induced by Blanchard's model. These responses are positively affected by the birth rate and by the degree of persistence of the budget deficit. Empirical results for the Canadian and US economies reveal that, although the relevant birth rates are small, the great persistence of the budget deficits yields responses that are numerically large and statistically positive. This contrasts with previous tests of the twin deficits hypothesis, which have never formally taken into account the stochastic properties of the budget deficit.