EFFECT OF PRIVATE DOMESTIC INVESTMENT ON THE U.S. TWIN DEFICITS

Abstract

ABSTRACT This paper investigates the effect of private domestic investment on the U.S. government and current account deficits in accordance with the twin deficits theory instead of the Ricardian equivalence proposition. This paper is an extension of a study on the effect of domestic saving on twin deficits, and affirms its findings. Results from a simple DSGE canonical approximation model from 1990 to 2012 indicate that lagged by one quarter first-order differenced investment is a weak destabilizer to both contemporaneous first-order differenced budget deficit and current account balance deficit. A shock in investment tends to increase rather than reduce changes in budget and current account variable, but with minor impact. The Euler consumption equation demonstrates that personal consumption expenditure can cause a very significant destabilizing effect on both budget deficit and current account deficit changes. Judd-Gaspar test suggests the approximation model is robust for both policy variables. Change in lagged current account deficit demonstrated more power on change in contemporaneous budget deficit. Results from this study shed light on causational effect of the twin deficits. Keywords Twin Deficits, Investment, DSGE Model, Judd-Gaspar Test.