International Business

Assignment 1

Jingze Yuan

The government budget deficit is the difference between government revenue (mostly taxes) and government spending; the current account deficit is the difference between exports and imports (there are some adjustments for items such as funds sent abroad). Both deficits occur when someone is spending more than they earn; during the last 25 years the US government has tended to spend more than it collects in taxes and US residents have tended to spend more on imports than they export.

A nation’s current account deficit reflects excess domestic spending. Equivalently, a current account deficit equals the excess of domestic investment over domestic savings. Regarding the Twin Deficit approach, Bernheim argues that if world capital markets are integrated and Ricardian equivalence does not hold, an increase in the budget deficit will almost certainly contribute to the current account deficit. A regression of the current account on the budget deficit (both scaled with GDP), while controlling for business cycle effects using growth and lagged growth gives a coefficient of 0.3 on the budget deficit in the case of the U.S. and similar figures for Canada, U.K. and Germany. Furthermore, tax smoothing implies a one-to-one relationship between the current account and the fiscal deficit. The underlying mechanism is that a constant tax rate induces the budget deficit to move one-to-one with public spending and therefore with the current account.

The external finances of the country can hardly be considered healthy as the country has a massive trade deficit and a large deficit in the current account of the balance payments. However, foreign investment recent years in the United States has remained broadly in line with the relative size of the U.S. economy and the U.S. capital markets. The key reason for this outcome has been rapid financial globalization, with cross-border flows worldwide rising as...