Budget Deficits and the Current Account Balance: New Evidence from Panel Data

By Mohammadi, Hassan | Journal of Economics and Finance, Spring 2004 | Go to article overview

Budget Deficits and the Current Account Balance: New Evidence from Panel Data


Mohammadi, Hassan, Journal of Economics and Finance


Abstract

This study examines two distinguishing predictions of the finite-horizon open-economy macroeconomic models regarding the effect of fiscal policy on the current account balance: (1) Given the path of government expenditures, a fall in public savings has an adverse effect on the current account balance, and (2) a bond-financed increase in government expenditures exerts a larger adverse effect on the current account balance than a tax-financed alternative. These predictions are vastly different from those of the Ricardian theory. According to this view, (1) lower public savings are met by equal increases in desired private savings, and thus the current account balance does not change, and (2) the response of current account balance to a change in government spending is independent of its financing methods. Empirical analysis of 63 countries is consistent with the conventional theory. (JEL: E6)

Introduction

A common feature of many industrial and developing countries over the past two decades has been their reliance on active fiscal policy, accompanied by large government budget deficits.1 A large number of theoretical and empirical studies have investigated the potential adverse effects of budget deficits on the economy. One area that has been the focus of attention is the effect of deficits on the current account balance. Theoretical examinations of this issue have resulted in two distinctively different predictions. The conventional view, expressed by finite-horizon overlapping generations models suggests that, for a given path of government expenditures, a decline in public savings due to a tax cut increases private savings by an amount that is smaller than the initial tax cut. [See Diamond (1965), Blanchard (1985), and Frenkel and Razin (1992).] As a result, national savings decline. In a closed economy, real interest rates rise to restore the equality between desired national savings and investment. That in turn crowds out domestic investment and reduces longrun capital formation. In an open economy with perfect capital mobility, however, real interest rates may not rise, but the increased borrowing from abroad may result in current account deficits.

In contrast, the alternative view exemplified by the infinite-horizon Ricardian theory suggests that the decline in public savings due to the tax cut is offset by an equal increase in desired private savings and that desired national savings remain unchanged. Thus in a closed economy real interest rates do not rise, and there is no effect on domestic capital formation. Similarly, in an open economy, there is no effect on the current account balance since desired private saving would rise enough to avoid having to borrow from abroad. [See Barro (1989, 1991).]

As Enders and Lee (1990) have noted, the most controversial aspect of the two theories is their policy implications. According to the conventional view, budget deficits are the primary cause of current account deficits. Thus its policy recommendation is to reduce budget deficits by raising taxes. Such a policy is expected to reduce private spending and net exports and improve the current account balance. In contrast, the Ricardian view suggests that the rise in taxes alone will not reduce the current account deficit. To do so, it must be accompanied by a cut in government expenditures.

The resulting theoretical ambiguity and distinct policy implications of the two theories have led to a host of empirical investigations. Such investigations fall into one of two categories: narrow models derived from the first principles as in Enders and Lee (1990) or broad reducedform specifications as in Congressional Budget Office (1989), Miller and Russek (1989), Kearney and Monadjemi (1990), Arora and Dua (1993), Mohammadi and Skaggs (1996, 1997), and Mohammadi (2000). The outcome of these investigations appears to depend on several factors including the empirical model, econometric technique, sample period, data transformations, and variable proxies. …

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