Abstract
ABSTRACTWe revisit the twin deficits hypothesis by examining the long-run cointegrating relationship between the US budget and trade deficits across various quantiles using a unique dataset for the period 1791–2013. The main results suggest the existence of nonlinearities and structural breaks in the relationship between the trade and budget deficits, indicating that the long-run relationship between the two variables has not been constant overtime. Furthermore, we find evidence in favour of the twin deficits hypothesis. Finally, the results suggest that the cointegrating coefficient in the long-run relationship between the two variables is not constant across different quantiles. In fact, we find that an increase in the budget deficit will have a greater effect on the trade deficit at quantiles below the median than at higher quantiles, suggesting that the effectiveness of restrictive fiscal policies directed to reduce trade deficits will depend on the actual size of the budget deficit.
Highlights
According to the twin deficits hypothesis, there is a strong link between a country’s trade and fiscal balances
We test the twin deficits hypothesis by analysing the long-run relationship between the trade and budget balances across various quantiles using a long span of data covering the time period 1791–2013 in the US
The theoretical explanation of this assumption relies on the different reaction of private agents following a fiscal policy change, which in turn depends on the conditional size of the trade deficit
Summary
According to the twin deficits hypothesis, there is a strong link between a country’s trade and fiscal balances. From a theoretical point of view, this hypothesis could be either justified or rejected depending on the assumptions made in the model. According to a Keynesian view and based on the Mundell-Fleming framework, a fiscal contraction will lead to a decrease in the current account deficit through a decrease in interest rates and a depreciation of the real exchange rate (Obstfeld & Rogoff, 1996). Under the Ricardian equivalence framework (Barro, 1989), the fiscal contraction will not lead to a decrease in the current account deficit since private agents will react by increasing private consumption, as these agents would like to save less given the expected future tax cuts.
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