ECONOMICS

The Twin Deficits

The Twin Deficits

Introduction

In economics, the twin deficits refer the situation of a country at the same time recording a deficit in its current account, that is to say a situation where spending governments exceed their income, and imports of goods and services exceed exports. The expression of twin deficits is used to characterize the U.S. economy in the early 1980s, and during the 2000s. The currency of the United States, the U.S. dollar, which acts as a reference currency in the world despite the demise of Breton Woods, probably allows the maintenance of such a situation on short and medium term, and illustrated in the Tiffin dilemma (Wolf, 1989). The causal relationship between deficits and public from outside the overlapping generations' model has been proposed by Olivier Blanchard in 1985 (Carvounis, 1987).

This model fits the twin deficits hypothesis (there is a positive relationship between deficits) and the assumption of Ricardian equivalence (there is no link between the deficits). A twin deficit is the type of dependency that exists in the economy between budget deficit and current account deficits. In practice, this hypothesis means that the maintenance of a high budget deficit could lead to current account deficit (Gibson, et.al, 1992). This essay focuses on the Twin deficits of USA economy, when in the 1980s they encountered with large government deficits and large trade deficits. Secondly it explains the reasons that why a trade deficit was not disappearing when in 1990s the government deficits were disappear. Lastly this paper addresses the implied change in net capital outflow and the advantages and disadvantages of a trade deficit.

Discussion

The concept of twin deficits in economics was originally linked to explain the strong correlation that existed between the fiscal deficit and current account deficit of balance of payments was evident in the United States in the decades of the seventies and eighties. The concept states that an excess of public spending that creates a deficit in fiscal accounts, increased domestic demand and this leads to higher imports, in parallel, a deficit in current account balance of payments in an economy (Sinai, 2000). Baxter, Kim, Roubini and Cavallo are some authors who have written on this subject and, at present, have expanded the concept of simultaneity of the deficit, without necessarily causation given that established the original concept. Even the concept has been extended to analyze other similar economic events as a banking crisis and a fiscal crisis. In common use, there are three channels through which it explains the phenomenon of twin deficits in United States (Dorn & Niskanen, 1989).

The first channel is assumed liquidity of the exchange rate and the free movement of capital, which is the situation of an open economy. It is maintained by a high budget deficit results in an increase of interest rate. Increased interest rate causes an inflow of foreign investment, which resulted in foreign currency shall be converted into national currency. This leads to an appreciation of domestic currency (Blecker, ...