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

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

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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.