Fiscal Policy, the Current Account, and the Twin Deficits Hypothesis

Abstract

The relationship between the fiscal policy and the current account balance is an open question for open economies analysis. Traditional view leads to the so-called "twin de cits hypothesis", which establishes a direct relationship between the government budget de cit and the current account de cit. However, intertemporal approach of the current account doubts on the existence of such a relationship. In this paper, we study this twin deficits hypothesis using a dynamic general equilibrium model in a monetary union context, in which it is considered the role of international investors in financing government de cit. We nd that the proportion of government debt purchased by foreign investment is a key factor in explaining the relationship between fiscal policy and the current account. In general, we obtain that the e¤ects of di¤erent shocks on the current account dynamics are magnified as the proportion of government debt held by foreign investors increases.