Budget deficits and the current account: An Intertemporal Disequilibrium Approach

Abstract

This paper reconsiders the effect of money-financed and tax-financed increases in government spending on output, the real exchange rate, and the current account of the balance of payments. This is done using an intertemporal optimization model of a monetary (i.e. cash-in-advance) economy where national output is demand determined in the short run. Walrasian equilibrium, however, prevails in the long run. It is shown that a permanent tax-financed increase in government spending has an ambiguous effect on the current account, but a money-financed increase always improves it. Temporary increases in government spending that are money financed, on the other hand, leave the current account unchanged.