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Corsetti and M ü ller’s “Twin Deficits: Squaring Theory, Evidence and Common Sense”

Explore the theory, evidence, and common sense behind Corsetti and Müller’s research on the twin deficits phenomenon. Delve into the intricate relationship between fiscal expansions, trade balance, and investment decisions, shedding light on the role of openness and fiscal persistence. Uncover how fiscal shocks influence returns on domestic and foreign investments, ultimately shaping trade dynamics. Discover the nuances of varying levels of open economies and home bias in impacting the return to capital. Gain a deeper understanding of the complex interplay between fiscal policy, trade balance, and investment patterns. This paper offers a comprehensive examination of the mechanisms driving the twin deficits and challenges conventional wisdom on the direct link between trade and budget deficits.

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Corsetti and M ü ller’s “Twin Deficits: Squaring Theory, Evidence and Common Sense”

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  1. Corsetti and Müller’s “Twin Deficits: Squaring Theory, Evidence and Common Sense” Frank Warnock Darden Business School, University of Virginia

  2. Basic Theme • Fiscal expansions have no effect on trade balance if • The economy is not open to trade • Fiscal shocks are not too persistent • With home bias, fiscal shocks drive wedges between • returns on domestic and foreign investment • r and r* • The wedges impact investment decisions and eventually the trade balance

  3. Mechanism • G falls on home goods, P goes up, and we get a lasting terms of trade appreciation. • returns on domestic investment increase • r also increases • Case 1: Stronger home bias • reduced impact of t on the return to capital • increased r-r* • Case 2: More open economies • fiscal shocks improve return to capital • muted impact on r-r*

  4. Mechanism • So the mechanism is through price changes which then impact quantities. • Evidence?

  5. Evidence on Quantities • Consistent with the model • In the relatively open countries (UK and CA), fiscal loosening results in a trade deficit but has little impact on investment. • In the relatively closed US, fiscal loosening has no impact on trade balance and results in a decline in investment. • Less consistent with the model • In the moderately closed AU, fiscal loosening has no impact on trade balance or investment. • Evidence on prices?

  6. Evidence on Prices • Inconsistent with the model • Responses of inflation and interest rates are positive or negative depending on the horizon • Terms of trade generally tend to depreciate • “Further analysis is needed to understand the response of inflation, the interest rate, and the terms of trade.”

  7. Where does this leave us? • Theory stresses the role of prices. • Empirical evidence on prices is not supportive. • “Further analysis is needed…”

  8. Bottom Line • Interesting, well-executed paper. • We have known that there isn’t a direct link between trade and budget deficits, but Corsetti and Müller teach us about the roles of openness and fiscal persistence. • I’d like to better understand the role of prices in this analysis.

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