INTRO

The topic of fiscal policy is important as It is used commonly as a response policy to big

economic shocks in the world to improve economic conditions during different phases of

the business cycle, such as in a recession; the type of fiscal policy employed will then

have long term effects on the economy and could make the economy come out or stay in

the recession. Furthermore, fiscal policy can have different effects on the current account

and trade; it can cause a twin deficit where a fiscal deficit leads to a current account deficit

or it can cause a twin divergence where a fiscal deficit leads to a current account surplus.

This was a key findings of standard theory and simple accounting according to Forni and

Gambetti, 2016 and Corsetti and Muller, 2006.

According to standard theory, the following mechanism is how a twin deficit occurs: an

expansionary fiscal policy through more government spending (G) would increase

aggregate domestic demand as AD= C+I+g+(x-m). This would increase the demand for

domestic currency/money shifting the money demand (IS) curve to the right. This would

cause an increase in the interest rate. This increase in interest rate would cause a

domestic currency appreciation. This is because domestic bonds will now have a higher

return and therefore higher demand for domestic currency in international capital markets.

Therefore, the current account would deteriorate as exports are now cheaper and imports

are dearer and trade would be affected negatively, and a twin deficit is reached.

However there is an argument based on historical data evidence that fiscal expansion

most often leads to an improvement of the current account (twin divergence). This was

one of the key findings in the Forni and Gambetti paper, 2016 and Kim and Roubini paper,

2006. Many papers such as Sachs, 1982 and Baxter, 1995, mention that this occurs due to

mechanisms which cause a depreciation of the real exchange rate (exchange rate puzzle)

when unexpected levels of output changes are controlled for.

However, whether a twin deficit or divergence occurs depends on two factors according to

key findings of the Corsetti et al paper where there is discussion related to Kim and

Roubini, 2003 paper. One of these factors is regarding to how open an economy is.

‘Openness’ of economy is defined by how freely a country can trade with other countries

with minimal restrictions. The second factor relates to the persistence of the fiscal policy

shock.

Most of these effects on the current account depend on what effect fiscal policy has on the

real exchange rate; this uncertainty is named the exchange rate puzzle. Forni and

Gambetti, 2016 and Kim and Roubini, 2008 have findings from the paper of Corsetti et al,

2012 and Frenkel, 1996, respectively, which imply that this could be due to habits of the

government to reduce spending and increase taxes following a fiscal expansion. Therefore

eventually causing a reduction in the prolonged real interest rate, leading to a fall in the

exchange rate and a current account improvement.

This exchange rate puzzle, which is key to account for when measuring effects of fiscal

policy on the current account; may be due to certain econometric issues. One of them

includes the problem of non-invertibility due to fiscal expectation (key finding of Yang, 2008

in Forni and Gambetti paper). The non invertible problem arises when the properties of

VAR predictions cannot account for structural shocks and are misrepresentative of the

impacts of a particular change in circumstance we are focusing on (in this case it’s

government spending changes).

Impacts and their characteristics on the exchange rate depend on the type of fiscal

expectations of agents (key finding of Ramey, 2016) fiscal expectations are split into two

categories which have their unique econometric contributions towards the exchange rate

puzzle. There are ‘news’ shocks which have immediate effect on the assumptions of

agents but change government spending in the future. And there are ‘surprise’ shocks that

change government spending quickly.

In this essay I will be reviewing key papers which touch on the effects of fiscal policy on

the current account and their key findings on the theoretical and empirical implications for

the effects on the current account. This will be done by analysing econometric

methodology such as structural VAR analysis based on Cholesky decomposition. Along

with this, we will discuss the potential use of additional econometric techniques which can

solve the exchange rate puzzle. Furthermore, I shall discuss empirical results using

impulse response functions based on economic theory and the policy implications from

these results.

THEORETICAL UNDERPINNINGS

In the Introduction there was brief mentioning of ways a twin divergence could occur. The

full theory explanations of them will now be covered. In Kim and Roubini, 2008, a fiscal

expansion could be followed by a depreciation in the real exchange rate and an

improvement in the current account in the following way: private savings could increase as

people realise that running a fiscal deficit where the government spends more than it

receives in tax revenue will cause an increase in public debt. Therefore people think that

there will be higher taxes in the future, so they save more now to pay this off (Corsetti et

al, 2006). Due to the fact that current account=savings-investment, more savings would

lead to a current account improvement. More saving and less spending in the economy

decreases the demand for domestic currency, reducing its value (Kim and Roubini, 2008).

This would lead to a depreciation of real exchange rate, meaning less foreign currency is

needed to obtain the same amount of domestic currency as domestic currency is now

weaker. The weakening of the exchange rate due to fiscal expansion is called the

depreciation puzzle. Domestic exports would now be relatively cheaper and net value of

exports increases, leading to an improvement in the current account.

Furthermore, as people expect higher taxes, they reduce their consumption, lowering

money demand (IS curve to the left), reducing interest rates, leading to domestic bonds

having lower return leading to lower demand in international capital markets leading to a

depreciation in domestic currency causing an improvement in the current account as

exports are now cheaper and imports are dearer. Also, when government spending

increases aggregate domestic demand would increase, increasing money demand and

therefore interest rates; this would then decrease investment. Decrease in investment

would improve the current account due to the equation mentioned above (ca=s-I).

The other way a twin divergence arises mentioned in the literature is through the following:

a fiscal expansion which causes a rise in the exchange rate (and therefore a current

account degradation) will eventually cause the government to go into a relative fiscal

contraction (“spending reversal”). This reduction in government spending would then

reduce the domestic aggregate demand in the economy and therefore a decrease in

money demand causing a reduction in the prolonged real interest rate; causing a fall in the

exchange rate (and therefore a current account improvement) (Corsetti et al, 2012).

There are a few theoretical approaches when explaining why twin deficits occur. The first

one is the traditional Mundell-Fleming Model approach. In Corsetti and Muller, 2016, this

approach implies that a rise in government spending causes a rise in aggregate demand in

the economy (as ad=c+I+g+(x-m)), This would increase the demand for domestic

currency/money shifting the money demand (IS) curve to the right. This would cause an

increase in the nominal interest rate. This increase in interest rate would cause a domestic

currency appreciation. This is because domestic bonds will now have a higher return and

therefore higher demand in international capital markets. This appreciation essentially

means that a foreign country would need more currency to obtain the same amount of

domestic currency, implying for the domestic country, exports would be dearer. This would

decrease the domestic country’s export demand and therefore decrease their export sales.
Since the current account is equal to net value of exports - net value of imports, due to the

value of exports decreasing, the current account would deteriorate and trade would be

affected negatively, and a twin deficit is reached.

On the other hand, it was also argued that the initial rise in interest rate would eventually

cause a better state of the current account (CA=S-I) through a decrease in investment

levels. But it was gathered that the extent of this reduction in investment would not be

enough to counteract the effect of appreciation of real exchange rate on the current

account.

The second approach is the intertemporal one. In Corsetti et al, 2006, this approach

implies the following: with a perpetual fiscal expansion;the initial fiscal and budget deficit

caused by this is completely counteracted by household private savings increases, leaving

no change to the state of the trade balance or current account. Private savings increase

due to higher expected future govt debt, providing expectations to household that future

taxes will increase (to finance this debt).

A Temporary rise in government spending will cause a twin deficit. The short lived nature of

this increase means that future expaevtaions of rises in taxes are now diminished.

Therefore private households’ savings undergo a minimal impact, and therefore have little

to none effect on the current account. Therefore the only impact on the current account

and trade balance will be due to the budget deficit;with this impact being a negative one.

In the Ahmed 1986 literature, it accounts for effects when there is a relatively big impact on

labour supply to changes in wages. When there is a perpetual increase in government

spending, present value of taxes will increase causing a reduction in household income.

Less income would imply less leisure consumption and more labour supply. If we take

capital and labour as being complementary to each other in nature; marginal product of

capital will rise. This would cause a worsening of the current account due to more
investment due to bigger return on investment for domestic country due to higher MPK

(CA=S-I) (Corsetti and Muller, 2016).

These two approaches mentioned above miss out effects on investment from imports

being cheaper and exports being dearer. With regards to impacts of changes in

government spending and/or taxation, the ignorance of investment hinders insights to

spillover impacts of the change to across the country’s borders.

To evaluate the significance of these spillover impacts, a discussion of what factors are

necessary for a twin deficit crisis to occur is needed. (Corsetti et al 2012)

The first factor is about how open the economy is. With an open economy with very good

capital mobility a twin deficit is more likely to occur. This is because when government

spending increases, domestic demand will rise causing money demand, the IS curve to

shift right. This will have affect interest rates in a fairly negligible way but with money

demand increasing, value of domestic currency will rise, causing an appreciation. This

causes domestic exports prices to rise and import prices to fall. Therefore investment

returns will rise (as cost of production falls due to lower import prices) meaning a higher

level of investment. Also, these dearer exports have a high probability of getting imported

by other countries, therefore the fiscal expansion would’ve caused an overall increase in

the return of investment. These factors would cause a current account deficit (ca=s-I)

causing a twin deficit (Corsetti and Muller, 2006).

The second factor relates to the persistence of the fiscal policy shock. This factor can have

a strong impact on whether a twin deficit or divergence occurs due to its unconsidered

effect that a rise in the real exchange rate has on investment choice and therefore whether

there is a current account improvement or degradation as CA=S-I. A fiscal expansion

which (concentrated on investment goods) causes export prices to rise relative to import

prices. These exports have a high probability of getting imported by other countries,

therefore the fiscal expansion would’ve caused an overall increase in the return of
investment and therefore the extent of investment due to the appreciation of real exchange

rate. Also, there is more investment because imports are now cheaper, reducing cost of

production. Hence, because of the high potential impact on investment; a strong effect on

the current account is likely, and therefore the long or short term nature of the fiscal shock

is crucial to whether there is a twin deficit (Corsetti and Muller, 2006).

However, a persistent government spending increase could also cause a twin divergence

in the following way: if households know that the shock is permanent, they will know that

this budget deficit will soon be funded through higher future taxes. Therefore to

compensate for these higher taxes, households will reduce their consumption, lowering

domestic currency demand, causing the real exchange rate to depreciate, leading to a

current account improvement.

The real exchange rate and therefore whether a twin deficit occurs is also affected by

output level changes. An output shock where there’s an increase in supply will increase

gdp levels (as SRAS curve shifts right) and therefore national income rises, causing higher

demand and consumption of goods and services domestically. The extent of this increase

in consumption is likely to be higher than the increase in supply levels. This would mean a

rise in exchange rate. In the long term, demand and supply will have to be of the same

level, therefore the previous appreciation of the real exchange rate will be no longer and a

depreciation if the real exchange rate will take place due to the supply rise in long term

(Corsetti et al, 2008).

ECONOMETRIC ISSUES

This exchange rate puzzle, which is key to account for when measuring effects on the

current account; may be due to certain econometric issues. One of them includes the

problem of non-invertibility due to fiscal expectation. The non invertible problem arises

when the properties of VAR predictions cannot account for structural shocks and are
misrepresentative of the impacts of a particular change in circumstance we are focusing

on (in this case it’s government spending changes). Whether there is an appreciation or

depreciation depends on the clarity of observed effects of fiscal policy/government

spending. Fiscal expectations reduce the certainty, clarity and direction of the effects of

government spending due to its effect on the efficiency of VAR analysis and compatibility

with it; With fiscal anticipation it is likely that VAR will produce wrong/inaccurate results

because VAR will not have adequate/enough data and therefore producing a non-

invertability problem with variables included. With no perfect foresight, there will be omitted

variable bias where the expectations will be in the error term and therefore will be

correlated with the right hand side variables.

Impacts and their characteristics on the exchange rate depend on the type of these fiscal

expectations of agents. Fiscal expectations are split into two categories which have their

unique econometric contributions towards the exchange rate puzzle. There are ‘news’

shocks which are shocks which are expected and have immediate effect on the

assumptions of agents but change government spending in the future. And there are

‘surprise’ shocks that are not expected and change government spending quickly while

anticipations are only affected when the change in spending is seen; the behaviour of the

exchange rate is in accordance with the expected government spending change after the

shock.

if these two particular assumptions of ‘news’ and ‘surprise’ shocks are not individually

respected and not given their own unique econometric rights; the exchange rate puzzle will

increase in its extent and will only be further away from being solved.

For example in an open economy VAR analysis, a surprise shock which includes

government spending increasing will cause the exchange rate puzzle. This is because,

due to the nature of the surprise shock, federal spending will increase straight away, but

then it will fall to lower level to what it initially was after a couple of years. This reduction in
government spending will cause a fall in the exchange rate through and enhance the

exchange rate puzzle through a fall in interest rate. (Forni and Gambetti, 2016).

Regarding the way the exchange rate puzzle could be solved, one way is having the

presence of news shocks in open economy VAR. When people expect a positive but

temporary news shock about government spending, they will not take into account the

spending reversal as it is due to happen years later. Therefore they believe that this

increase in government expenditure will not be funded by taxes anytime soon so people

increase their consumption. A rise in consumption increases domestic currency/money

demand, shifting the IS curve to the right and causing a rise in real interest rate. This rise

in real interest rate will cause domestic bonds to have a higher return and therefore higher

demand for domestic currency( in international capital markets). This would cause a

currency appreciation; solving the exchange rate puzzle.

Findings show that non fundamentalness is not the reason for the exchange rate puzzle in

open economy VAR and therefore a new method based on VAR is used to explain this

reason by focusing on anticipated shocks (news). This is done by introducing a variable in

VAR that is impacted by anticipated government spending changes at the same time by

using reliable published government spending expectations (Ramey, 2011). Cholesky

decomposition will then place this variable (news shock) as the 2nd residual while placing

the unanticipated shock (surprise) first.

We come to find in corsetti et al, 2012, that the introduction of the new variable (2nd in

order) by Ramey doesnt solve the exchange rate puzzle caused by unanticipated shocks.

However if the order of the variables are switched, it is found that the spending change

has delayed impacts on spending leading to its reduction, during the same time frame.

Therefore, domestic currency would now be stronger, enhancing and not solving the

exchange rate puzzle. This means this new variable cannot account for fiscal foresight

shock.
EMPIRICAL RESULTS DISCUSSION

Figure 1: Government spending impulse response functions (with Hamilton filter)

From figure 1 we see, there is a positive government spending shock (fiscal expansion)

which is long-lived and significant for just less than 20 quarters. Despite the increase in

spending, there was a negative surprise shock (government spending change impacting

news) which was long-lived, significant from the 4th quarter and onwards; possibly due to

the decreasing rate of the fiscal deficit.

The increase in government spending lead to a short lived non significant impact on the

real exchange rate for 7 quarters and then causes a fall in the exchange rate for around 10

quarters with its impact being significant. There is a fall in exchange rate possibly because

people expect that this increase in government spending is permanent and therefore will

be funded by higher taxes in the future. Therefore, these people reduce their consumption,

lowering money demand (IS curve to the left), reducing interest rates, leading to domestic

bonds having lower return leading to lower demand in international capital markets leading

to a depreciation in domestic currency.

This depreciation possibly caused the positive, persistent and significant increase in net

exports in proportion with gdp. This is because with a weaker currency, exports are

cheaper.

There is then a positive but short lived impact on consumption for a few quarters. This

positive correlation is possibly because when government spending increases, taxation

levels decrease. With lower taxes, household disposable income is likely to rise and

therefore could lead to higher consumption of households. However consumption then

decreases for about 10 quarters after. This is possibly because of the nature of surprise

shocks where agents analyse their expectations after the spending change has taken

place. Agents might think that this spending shock is permanent and therefore believe

they’ll be higher future taxes to fund this spending, causing consumption to fall.

Furthermore, gdp has a very similar pattern with impact of the same extent to that of

consumption in response to increased government spending. There is a positive but short

lived impact on gdp for a few quarters and then gdp decreases for 10 quarters after. This

identical pattern of gdp changes to consumption changes is because gdp=c+I, where

consumption is the main driver of gdp changes as the response of investment was likely

not significant.

Overall, from this figure we see that this persistent fiscal expansion has some positives

and negatives. For the maximal benefit, we have to take into account that this economy

could be relatively closed as investment responses were not very significant. Furthermore,

reducing the long lived nature of the fiscal expansion could bring about more advantages

such as more and longer periods of consumption increases and therefore could increase

gdp levels. Therefore, a more temporary fiscal expansion could be more beneficial.
Figure 2: news shocks impulse response functions (with Hamilton filter)

We see above in figure 2, a positive news shock which holds significance for 15 quarters;

that is that agents expect a positive change in government spending. Therefore, this leads

to a slightly delayed (but persistent) rise in government spending from the 1st quarter.

There is then an increase in the real exchange rate with it stopping at 3rd quarter for a

short amount of time and carrying on to increase after it. The increase of the real

exchange rate following a positive news shock (followed by more govt spending) is

because more government spending would cause higher interest rates. Higher interest

rates would cause domestic bonds to have a higher return and therefore higher demand

for domestic currency causing a domestic currency appreciation.

We then see that impact on net exports is a negative one for about 15 quarters. This

negative impact is because exports are now dearer due to the rise in real exchange rate.

The impact on consumption is a positive but very short lived one (for first 4 quarters). The

positive nature could be explained due to the households thinking that this government

spending increase is temporary and therefore won’t be followed by higher future taxation,
causing more domestic demand and household disposable income and therefore more

consumption.

There is only a rise in gdp from the 3rd to 4th quarter. The pattern of gdp is similar but not

identical to the consumption pattern. Gdp=c+i; the similarity is due to the consumption

changes being significant for a very short amount of time. However the pattern is not

completely identical as investment must’ve been affected aswell perhaps due to the

increase of interest rate mentioned previously.

From these effects, if the goal is to improve the current account and increase the level of

exports; a fiscal contraction would be best, where government spending decreases, as it

could raise the level of exports by reducing consumption (lower currency/money demand)

which would lower interest rates and cause depreciation of the currency. This depreciation

could potentially improve the current account by making exports cheaper. Furthermore, the

reduction in interest rates could increase investment (depending on the openness of this

economy) therefore gdp levels.

Figure 3: government spending impulse response functions (log-levels)

These graphs in figure 3 are impulse response functions without any filter, with the impulse

on government spending. We can see that there’s an increase in government spending for

11 quarters. This has possibly cause a depreciation in exchange rate where it’s

significance occurs after a year and continues for the rest of the quarters in graph. There’s

a depreciation because people expect higher taxes, they reduce their consumption,

lowering money demand (IS curve to the left), reducing interest rates, leading to domestic

bonds having lower return leading to lower demand in international capital markets leading

to a depreciation in domestic currency causing an improvement in the current account as

exports are now cheaper and imports are dearer.

Due to this government spending reversal causing higher future taxes, we see

consumption having a persistent and negative effect.

We also see a negative and persistent effect on gdp from the 2nd quarter onwards. This is

because the consumption decrease cause the exchange rate to fall leading to a fall in

return of domestic investment. Therefore as consumption and investment decrease, gdp

falls.

There is no significant impact of government spending on news.

Figure 4: news shock impulse response functions (log-levels)

Figure 4 above is the impulse response function with the impulse on news shock. We see

that the news shock is short lived and then becomes non significant with a lag impact on

the rest of the variables.

There is an appreciation of the real exchange rate from the 3rd to 9th quarter. This is

because people expect government spending to increase which causes an interest rate

rise. This leads to domestic bonds having a higher return and therefore higher demand,

therefore appreciation real exchange rate.

We then see reduction of net exports/gdp from the 3rd to 16th quarter. This is due to the

appreciation of the exchange rate, as exports would now be dearer, reducing their

demand.

We also see that consumption rises until the 11th quarter. This means that households

think that the government spending increase is temporary and won’t be funded by higher

future taxes. Therefore households are comfortable with increasing their consumption.
Also, since consumption increases, gdp rises as gdp=c+I. However, we see that the output

increase is more than the consumption increase because investment also increased due

to the appreciation of the real exchange rate mentioned previously. The rise in gdp was

significant for 6 quarters.

In figure 5 (in appendix), we see all are inside the unit root meaning the angular variance is

less than one, implying stability of the data.

CONCLUSION

Overall, this paper has analysed the impact of the type of fiscal policy on the current

account and different ways in which the current account is affected such as through the

real exchange rate. I have done this by generating and interpreting impulse response

functions with impulses on different fiscal policy related shocks which impact the current

account; aswell as reviewing effects on the current account when structural VAR model

with Cholesky decomposition is used in Forni and Gambetti paper (2016), (Ramey, 2011).

Standard theory almost always implied that the result of a fiscal expansion was a twin

deficit, llori et al, 2022, (Beetsma and Giuliodori, 2011). However, based on empirical

evidence, an increase in government spending lowered the real exchange rate and

therefore improved the current account, Kim and roubini, 2008 (Corsetti et al, 2006); and

therefore it is gathered that the main effect of a fiscal expansion is a twin divergence and

not a twin deficit.

The main mechanism which was found to be the cause of a twin divergence was through

the Ricardian effect where investment decreases and private savings rise causing a

current account improvement as ca=s-i (Corsetti et al, 2006). It was found that other

drivers of twin divergence were government spending reversals (Corsetti et al, 2012) and

positive supply shocks (Corsetti et al, 2008).

There were theoretical reasons why a twin deficit might occur such as through the

appreciation of real exchange rate in the Mundell-Fleming Model in Forni and Gambetti

paper (Corsetti et al, 2006), through an open economy and persistent government

spending increases (Corsetti and muller, 2012). However there was very little empirical

evidence backing these theories especially in the Forni and Gambetti paper (Muller, 2006).

Therefore, based on empirical and theoretical information, the policy recommendation in

order to improve the current account would be to carry out a medium-run expansionary

fiscal policy, as it has more historical data support aswell as clear theoretical support to

back up its result of a twin divergence.

APPENDIX

Figure 1: Government spending impulse response functions (with Hamilton filter)

Figure 2: news shocks impulse response functions (with Hamilton filter)

Figure 3: government spending impulse response functions (log-levels)
 Figure 4: news shock impulse response functions (log-levels)

Figure 5: roots of companion matrix

 References

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sense,' Economic Policy, 21(48), pp. 598–638. https://doi.org/10.1111/

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Forni, M., Gambetti, L. and Research, C. for E.P. (2014) Government spending shocks in open

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Ilori, A., Páez-Farrell, J. and Thoenissen, C. (2022) 'Fiscal policy shocks and international

spillovers,' European Economic Review, 141, p. 103969. https://doi.org/10.1016/

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