Twin deficit hypothesis
From Wikipedia, the free encyclopedia
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The twin
deficits hypothesis is a concept from macroeconomics
that contends that there is a strong link between a national economy's current account balance and its government budget balance.
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[edit] Definition
As an
example, it is hypothesized that a large budget deficit leads to a large
current account deficit. The theory goes as follows:
Y = C
+ I + G + NX
where
Y represents National Income or GDP, C is consumption, I is investment, G is
government spending and NX stands for net exports. This represents GDP because
all the production in an economy (the left hand side of the equation) is used
as consumption (C), investment (I), or government spending (G), and the
leftover production is exported (NX). Another equation defining GDP using
alternative terms (which in theory results in the same value) is
Y = C
+ S + T
where
Y is again GDP, S is savings, and T is taxes. This is because national income
is also equal to output, and all individual income either goes to pay for
consumption (C), to pay taxes (T), or becomes savings (S).
[edit] Proof
Since Y = C
+ I + G + NX, and Y = C + S + T, then C + I
+ G + NX = C + S + T, which simplifies to (S
− I) + (T − G) = (X − M)
If
(T-G) is negative, we have a budget
deficit.
Now,
assume an economy already at potential output, meaning Y is fixed. In this
case, if the deficit increases, and savings remains the same, then this last
equation implies that either investment (I) must fall (see crowding out), or net exports (X-M, or NX)
must fall, causing a trade deficit. Hence, the twin deficits.
Though
the economics behind which of the two is used to finance the government deficit
can get more complicated than what is shown above, the essence of it is that if
foreigners' savings pay for the budget deficit, the trade deficit grows. If the
countries own citizens' savings finance the borrowing, it may cause a crowding
out effect (in an economy at or near potential output, or full employment).
[edit] Example
In the
US, the budget deficit is financed about half from foreigners, half domestically.
Therefore, with a $400 billion deficit, the trade deficit would, according to
the theory, be increased by some $200 billion.
"Double deficit" in the USA.
Fiscal balance (black) and current account balance (red). Source: ameco[1].
An economy
is deemed to have a double deficit (also known as a twin deficit)
if it has a current account deficit and a fiscal deficit.
In effect, the economy is borrowing from foreigners in exchange for
foreign-made goods. Traditional macroeconomics
predicts that persistent double deficits will lead to currency devaluation/depreciation
that can be severe and sudden.
In the
case of the United States, the twin deficit graph as a percentage of GDP shows
that the budget and current account deficits did move broadly in sync from 1981
until the early 1990s, but since then, they have moved apart. Data thus
confirms that as a government budget deficit widens, the current account falls,
but the relationship is complicated by what happens to investment and private
saving.
CA(X − M) = (private)S
− I + (T − G)
CurrentAccount = (PrivateSavings − Investment)
+ (Tax − GovernmentExpenditure)
Above
the equation, it's verifiable that CA will deteriorate as government
expenditure exceeds the amount of tax is collected.
One
way to understand this process intuitively is by thinking through two different
markets. First consider the Foreign Exchange market. At equilibrium the
quantity supplied=the quantity demanded. Thus, Imports + Capital
outflow=Exports + Capital Inflow. Rearranging this equation we find that
Imports-Exports=Capital Inflow-Capital Outflow. Because Imports-Exports=Trade
Deficit and Capital Inflow-Capital Outflow=Net Capital Inflow, we get the
equation Trade Deficit=Net Capital Inflow (or Current Account deficit = Capital
Account Surplus).
Next
we must consider the market for loanable funds. The equilibrium here is
Savings+Net Capital Inflow=Investment+Budget Deficit. However, taking the Forex
market into consideration we know that the Trade Deficit is equal to Net
Capital Inflow. We can thus substitute for:
Savings + TradeDeficit = Investment
+ BudgetDeficit.
Rearranging
algebraically we find that:
BudgetDeficit = NetSavings + TradeDeficit
− Investment.
What
we can gather from this is the understanding of why an increased budget deficit
goes up and down in tandem with the Trade Deficit. This is where we derive the
appellation the Twin Deficits: if the US budget deficit goes up then either
household savings must go up, the trade deficit must go up, or private investment
will decrease.
[edit] References
- Ghosh,
Atish; Ramakrishnan, Uma (December, 2006), "Do
Current Account Deficits Matter?", Finance and Development vol. 43 (number 4), http://www.imf.org/external/pubs/ft/fandd/2006/12/basics.htm
Retrieved from "http://en.wikipedia.org/wiki/Twin_deficit_hypothesis"
