Fiscal policy and trade adjustment: are the deficits really twins?

Since the mid 1980s, an extensive emprical literature has examined the relationship between U.S. Fiscal deficits, exchange rates, and trade balances. We investigate two questions that continue to spark debate: do increased government deficits casue doller appreciation, and do fiscal deficits lead to higher trade deficits (the popular ‘twin deficit’ notion)? We examine these issues fusing a five-variable VAR system, generating posterior probability bounds to assess significance. Our result provide some evidence that growing goverment deficits apperciate the dollar, and support the “twin deficit” notion that government deficits contrinute to trade deficits.

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