Academic journal article American Economist

The Relationship of the Current Account Balance and the Budget Balance

Academic journal article American Economist

The Relationship of the Current Account Balance and the Budget Balance

Article excerpt

When Australia is mentioned many images come to mind including Crocodile Dundee, the last frontier, and the lucky country. However, Australia is not as "lucky" as its image. Australia has one of the world's highest living standards in the world but a foreign debt comparable to that incurred by third world nations. An ongoing sign of the magnitude of the foreign debt accumulation is the current account deficit. The current account deficit has risen to A$15 billion dollars and makes up four percent of the gross domestic product(GDP). (7)

In the early eighties, Australia was running a large budget deficit. The government took active measures to turn this around and is now operating with a large budget surplus. While achieving a surplus, the government hoped Australia's foreign debt accumulation, represented by the current account deficit, would become smaller. However, the problems in the economy are deeper than just turning the budget deficit around. The desired effect on the current account deficit did not occur; in fact the current account deficit became larger.

This paper includes a discussion of two opposing theories underlying the relationship of the budget deficit to the current account deficit. The first is the traditional theory, which is based on the IS-LM model, which states that as the government budget balance increases the current account should also increase. In contrast, the Ricardian Equivalence theorem suggests that if the government budget balance is positive, there will no longer be expectations of an increase in taxes and in turn, households will lower their private savings. The Savings-Investment Identity shows that the current account does not necessarily follow the positive direction of the government budget balance.

The second section analyzes the Australian economy's current account. Two approaches are used: The first, using regression, shows that the government budget balance did not have a statistically significant impact on the current account balance. It indicates that the theory behind the traditional model is not supported in the case of Australia. The second approach analyzes the investment identity data by looking at individual figures for each year. Both approaches suggest that the Ricardian Equivalence Theorem provides a better explanation of the Australian current account than the traditional model. By applying two contrasting theories to the relationship between the current account balance and the budget balance using Australian data, this paper clearly shows that the Australian current account balance and the budget balance were not directly related.

Economic Theory

The Traditional Model

It is commonly believed that a decrease in the budget deficit has a positive effect on the current account deficit. If a country begins to decrease its budget deficit, that is if taxes increase or government spending decreases, as shown in Figure 1, the IS curve would shift back causing GNP and interest rates to fall. The drop in interest rates would cause the currency to depreciate and net exports to increase. This shift back in the IS curve also causes the aggregate demand curve to shift back. Since prices are sticky they will not change in the short run. In the long run, the LM curve will shift out to bring the economy back to potential GNP. This causes interest rates to drop even further. There will also be movement along the aggregate demand curve as the economy moves back to equilibrium. This increase in net exports causes a current account deficit to decrease or current account surplus to increase.

Ricardian Equivalence

Ricardian Equivalence suggests that the budget balance and current account balance are not directly related, as concluded from the traditional model.(1) This theory can be explained with reference to the Savings-Investment Identity.

Sr = I - Sp - Sg (1)

This says that world savings equals investment minus private savings minus government savings. …

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