Week 7 - Twin deficits: Fiscal deficits and Current account imbalances

Question 1

What two factors make up savings?

Answer 1

Sp and Sg: Sp= Private savings, Sg=Government savings ( e.g fiscal surplus/deficit)

Question 2

What is the twin deficit hypothesis?

Answer 2

The joint occurrence of a fiscal/CA deficit leads to a hypothesis that fiscal deficits cause current account deficits.

Question 3

What is 1 piece of evidence in favour of the twin deficit hypothesis?

Answer 3

For the US we see that after 1981 where the fiscal deficit was zero and the CA was zero, there is a large fall in both suggesting that a fiscal deficit is a cause of a current account deficit.

Question 4

Give 4 pieces of evidences against the twin deficit hypothesis?

Answer 4

1. World War II - Large fiscal deficit but the Current account didn’t react heavily
2. Clinton Era - Large positive fiscal surplus while CA was decreasing
3. Financial Crisis 2008 - Large fiscal deficit whilst the current account became more positive.
4. The Big Picture - Data observed from over time shows there there is no relationship

Question 5

What is the inter temporal budget constraint for households equal to?

Answer 5

C1+C2/1+r1 = Q1 + Q2/1+r1 +(1+ro)Bop - T1 -T2/ (1+r1)

The present discounted value of consumption = The present discounted value of the endowment + the initial wealth - Taxes

Question 6

What is equal at the optimal consumption level?

Answer 6

At the optimal consumption choice, the slope of the indifference curve -(1+r1) is the same as the slope of the intertemporal budget constraint.

Question 7

What is the equilibrium for both consumers and households, and describe the equation.

Answer 7

C1 + C2/1+r1 + G1 + G2/1+r1 = Q1 + Q2/1+r1 + (1+ro)(BoP + Bog)

RHS: All resources of the economy which is its endowment and initial financial wealth of a country ( determined by the private sector initial wealth + the public sector initial wealth) must equal the LHS. LHS= The resources used to fund consumption in both sectors which is the present discounted value of consumption plus the present discounted value of the endowments

Question 8

What final observation can we make about taxation and the current account and which equation shows this?

Answer 8

Collecting both T1 + T2/1+r1

We see that an economies resource allocation depends only on G1 and G2 and is independent of T1 and T2. If we keep spending fixed and cut taxes there will be no real effect on the current account because you are simply expecting higher tax in the future.

Question 9

What is the effect of tax cut on the government inter-temporal budget constraint?

Answer 9

A tax cut in period 1, leads to a tax increase in period 2 in order to finance the fiscal deficit.

This can be shown in the equation by assuming Bog=0 and the Change in G1 and G2 = 0.

We get 0 + 0 = Change in T1 + Change in T2/ 1+r1

Rearranging we get the change in T2= -(1+r1)Change in T1 (a tax cut in period 1 leads to a tax increase in period 2 in order to finance the fiscal deficit)

Question 10

What is the effect of a tax cut on the intertemporal budget constraint for households?

Answer 10

Due to households being forward looking a tax cut in period 1 leads to households saving the entire tax cut as they believe taxes will increase in the next period, which means consumption is unchanged.

Question 11

What Is the Ricardian equivalence?

Answer 11

Ricardian equivalence believes that a change in taxation in period 1 will have no effect on consumption in period 2. A tax cut in period 1 will lead consumers to save the tax cut as they fear a increase in period 2. As a result their consumption remains untouched.

Question 12

What is the effect of a tax cut on the current account

Answer 12

There is no change in the current account. As due to a tax cut and a fiscal deficit the fall in government leads to an opposite increase in private savings cancelling on another out.

Question 13

What is the link between the Ricardian Equivalence and the fiscal deficit?

Answer 13

When the Ricardian equivalence and the fiscal deficit is caused by a tax cut then the twin deficit hypothesis does not hold

Question 14

Using a diagram explain how households adjust to a temporary increase in government spending, and explain why the shift is diagonal and not horizontal

Answer 14

• See notes for diagram
• An increase in government spending reduces resources for consumers this leads to a shift in of the budget constraint as the consumer has less resources.
• AB is a diagonal shift and not a horizontal. This is because the agent does not want to reduce their consumption in period 1 by the same magnitude as the increase in government spending

Question 15

What is the effect on consumption from an increase in government spending?

Answer 15

Consumption falls, but it falls by an amount less than the increase in government spending

Question 16

What is the effect on the trade balance and the current account from an increase in government spending?

Answer 16

The trade balance is given by: Q-C1-G1 deteriorates, but by less than the increase increase in government spending.

The CA which is given by: CA=TB1+roB*o also deteriorates but by less than the increase in government spending.

Question 17

Explain how the Intergenerational effects lead to the failure of the Ricardian equivalence

Answer 17

• Generation that benefits from the tax cut not the same as the generation that pays for the future tax increase
• Therefore a tax cut in period 1 leads to an equal increase in consumption in period 1
• This leads to private savings equaling 0, and we known Change in CA=Change in savings=Change in govt savings(private savings=0), Change in government savings = change in taxes(fiscal deficit) which Is less than zero showing the current account deteriorates
• This disagrees with the Ricardian equivalence which states there will be no change to the current account