1. Is the budget deficit of a country linked to its current account balance? If
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Question
1. Is the budget deficit of a country linked to its current account balance? If so, how so? If not, why not? Explain how it is possible for the United States’ current account deficit to grow while the budget deficit has disappeared. Hint: There’s an equation that will help answer this question.
2. When looking at a nation’s financial account, is it possible to determine the total amount of official reserves available to that nation? If so, explain why. If not, explain why not
3. What can you say about the sign of the financial account if the government budget is balanced, and S is greater than I? Why?
Explanation / Answer
Yes,the Budget Deficit of a country can be linked to its CUrrent Account Balance.This situation is called a Twin Deficit Hypothesis.
This link can be seen from considering the National accounting model of the economy:
Y=C+I+G+(X-M)
An economy is deemed to have a double 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.
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 confirm 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(NX) = (private)S - I + (T-G)
Current Account = (Private Savings - Investment) + (Tax - Government Expenditure)
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 + Trade Deficit = Investment + Budget Deficit.
Rearranging algebraically we find that:
Budget Deficit = Savings + Trade Deficit - 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.
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