From the general equilibrium perceptive, this study proposes the inclusion of private savings and investments in examining twin deficits hypothesis. Using U.S. data, the empirical results support twin deficits hypothesis but the budget deficit’s elasticity is decreasing from unity to 0.43.General Equilibrium; Government Budget Deficits; Current Account Balance; U.S.

Evan Lau

Tuck Cheong Tang

English

Research Papers in Economics

1 
 
 
 
 
Department of Economics 
Issn 1441-5429 
Discussion paper 09/09 
 
General Equilibrium Perception on Twin Deficits Hypothesis: An 
Empirical Evidence for the U.S. 
 
Tuck Cheong Tang
* and Evan Lau
† 
 
 
 
 
Abstract: 
From the general equilibrium perceptive, this study proposes the inclusion of private savings and 
investments in examining twin deficits hypothesis.  Using U.S. data, the empirical results support twin 
deficits hypothesis but the budget deficit’s elasticity is decreasing from unity to 0.43.     
 
 
 
Key words: General Equilibrium; Government Budget Deficits; Current Account Balance; 
U.S. 
JEL classifications: F32; H62 
 
 
 
 
 
 
 
 
 
                                                 
* Corresponding author.  Monash University Sunway campus.   Email: tang.tuck.cheong@buseco.monash.edu.my 
† Corresponding author. Universiti Malaysia Sarawak (UNIMAS).  
 
 
© 2009 Tuck Cheong Tang and Evan Lau 
All rights reserved. No part of this paper may be reproduced in any form, or stored in a retrieval system, without the prior 
written permission of the author. 
 
 2 
 
 
1. Introduction 
A series of papers in a special issue of Journal of Policy Modeling (Vol. 28 No.6, pp. 603-
712, 2006) dedicates a substantial debate on “Twin deficits, growth and stability of the US 
economy”. Eventually, there is a substantial volume of studies available in the literature 
describes the theoretical framework and empirical results about the possible linkages (and co-
moving) between government budget deficit (BD), and current account deficit (CAD). 
Concern raise up by Obstefeld and Rogoff (2005) and Mendoza et al., (2007) that unless 
major policy actions are taken, these imbalances will generate global financial turbulence and 
the current crisis can be viewed as the outcome of these episodes.  
 
Historically, the so-called ‘twin deficits hypothesis’ arose during the “Reagan fiscal 
experiment” in the 1980s, marked a period of strong appreciation of the dollar with unusual 
shift hike in current account deficits. Several observations have confirmed that the 
unsustainable budget deficit during these periods has widens current account balances 
(Darrat, 1988, Bachman, 1992, Leachman and Francis, 2002). By and large, the existing 
studies on twin deficits phenomenon are mainly focused on the interrelationships and/or co-
moving relation in a bi-variate framework between budget deficits and trade balances (or 
current account balances). Interestingly, Cavallo’s (2005) article entitled “Understanding the 
Twin Deficits: New Approaches, New Results” has highlighted that  other things are not 
always equal, and a number of factors may affect how much budget deficits explain current 
account deficits.   
 
Using the derivation from general equilibrium perception, this study proposes an alternative 
framework to test the twin deficits hypothesis in which two additional macroeconomics 
variables i.e. private savings, and domestic investments are included. This study demonstrates 
an empirical support of twin deficit hypothesis by using the U.S. data.  
 
Next section discussion the twin deficits hypothesis in terms of general equilibrium 
perception, and section 3 reports the data, and results.   Section 4 concludes the section.  
 
2. Theoretical Framework  
The conceptual understanding of the twin deficits hypothesis is theoretically built from the 
commonly documented identify - national income identity: 3 
 
 
Y = C + I + G + NX              (1) 
where Y is real GDP, C is private consumption, I is investment, G is government purchases, 
and NX is net exports which is the different between exports (X) and imports (M).   And, the 
NX is also called CAB (current account balance).  A rewriting of the national income 
identity, the CAB relation can be delivered as following: 
 
NX = (Y – C – G) – I 
CAB = (Y – C – G) – I          (2) 
Again, the national saving, S is the national income after subtracting the spending on goods 
and services by private (C) and public (G) sectors.   
  
C A B   =   S   –   I         ( 3 )  
where S = S
p + S
g. S
p is private saving which is derived from Y – T – C, while S
g is 
government saving T –G.  T is tax revenue.  If, T > G indicates budget surplus (BS). But for 
the case T < G, the Government budget is in deficits (BD).  From the general equilibrium 
relation (3), the balance budget occurred when T = G.  The twin deficits hypothesis can be 
expressed in the following relation.   
 
CAB = BD + S
P  – I          ( 4 )  
Other things being equal, a precise focus on this relation yields two theoretical observations.  
First, there are possible for at least one cointegrating relation or long run equilibrium among 
the variables CAB, S
P, BD, and I. More precisely, one of the long run relation identified by 
standard economic theory is CAB and BD relation.  The second observation is a positive 
impact of BD on CAB (i.e. twin deficits hypothesis), in which other theoretically justified 
variables (private savings and investments) do play a role in validating this relationship as 
noted early in Cavallo (2005). Conversely, the twin deficits hypothesis is hold if the 
estimated coefficient of BD (equation 4) is statistically difference from zero at conventional 
levels i.e. 10%, 5%, or 1%. 
 
3.    Data and Empirical Results 
Data 
The U.S. data for current account balance (CAB), government budget balance (GB), 
investment (I), and private savings (S
p) (i.e. subtracting S with GB) are obtained from the 4 
 
International Financial Statistics, IFS (International Monetary Fund, IMF).  The variables are 
measured in real terms (and in $US billions) by deflating the nominal value with GDP 
deflator.  The sample period covers quarterly observations between 1973Q1 and 2008Q3.  
Table 1 shows the results of unit root tests (ADF) that all time series are non-stationary in 
levels at 10% level of significance, expect for investment (I). All series are stationary in fist 
differenced form (at least 0.10 levels).   
 
Table 1 Results of Augmented Unit Root tests (p-values) 
 
  Data in levels 
Constant and trend 
Data in first difference 
Constant 
LnCAB 
LnGB 
LnI 
LnS
p 
0.9961 (11) 
0.7227 (7) 
0.0911 (12) 
0.1725 (12) 
0.0722 (13) 
0.0019 (6) 
0.0004 (12) 
0.0114 (11) 
Note: The number in (.) denotes the lag length suggested by AIC from a maximum of 13 lags. 
 
 
Empirical Results 
On the other hand, the results of Johansen’s multivariate cointegration tests suggest at least 
one cointegrating vector among the four variables (i.e. l2 lags) which is consistent with 
theoretical intuition of two cointegrating relations as suggested by theories, namely twin 
deficits hypothesis (CAB and GB), and capital mobility hypothesis (S and I).     
Table 2 Johansen’s multivariate cointegration tests 
 
Data Trend:  None 
Test Type  No Intercept 
 No  Trend 
Lags interval: 1 to 4  
     Trace  1 
     Max-Eig  1 
Lags interval: 1 to 5  
     Trace  1 
     Max-Eig  1 
Lags interval: 1 to 12  
     Trace  2 
     Max-Eig  2 
 Notes; *Critical values based on MacKinnon-Haug-Michelis (1999).  VAR Lag Order Selection Criteria – 
Schwarz information criterion and Hannan-Quinn information criterion suggest 4, and 5 lags, respectively. 
Sequential modified LR test, Final prediction error, and Akaike information criterion 12 lags (maximum lag 
order) 
 
 
The twin deficits hypothesis is typically tested by a simple linear regression equation i.e. 
LnCABt = b1LnBDt + et.  The OLS (ordinary least squared) estimation is presented as 
equation (6). The estimated elasticity is found to be close to unity, 0.978.  5 
 
 
t t LnBD B A LnC 978 . 0 ˆ =        
   (t-ratios)      (90.350)         (5) 
 
Implicitly, the residuals series of this specification does capture the omitted variables 
suggested by equilibrium relation (4), namely savings (S
p), investment (I) (or capital 
mobility).  Thus, the estimated residuals series of equation (5) does not reflect cointegration 
property between current account balance, and government budget position, but savings-
investment relation.  Following equation (4), an OLS regression model can be estimated i.e. 
t t t
p
t t e LnI b LnS b LnBD b CAB + − + = 3 2 1  where bi  are the estimated parameters, and et is 
residuals.  Firstly, the coefficients of private saving (S
p) and investment (I) are restricted as 
suggested by theory i.e. b2 = 1, and b3 = -1.  The OLS estimator yields:- 
 
t t
p
t t LnI LnS LnBD B A LnC − + = 000 . 1 ˆ  
(t-ratios)      (102.705)             (6) 
 
The elasticity of BD is close to equation (5). Consistently, the restrictions imposed on private 
savings and investments reflect residuals series in equation (5).  Equation (7) reports the 
estimates of parameters of equation (4) without any restrictions.  
 
t t
p
t t LnI LnS LnBD B A LnC 707 . 4 164 . 5 431 . 0 ˆ − + =  
(t-ratios)      (6.293)             (15.949)           (-15.204)    (7) 
 
All of the estimated parameters are statistically difference from zero with reasonable large t-
ratios.  Interestingly, the estimated coefficients for private saving (S
p) and investment (I) both 
are not numerically equal to -1, and 1, respectively as theory suggests.  The Wald test statistic 
(F-statistic) of testing the sum of coefficients of S
p, and I equals zero (i.e. H0: b2+b3 =0) is 
87.602 (p-value is 0.000) rejecting the null hypothesis, and the elasticity of budget deficit on 
current account balance is found to be inelastic, 0.431 which is half of the values estimated as 
equations (6) and (7), but it is statistically different from zero (t-ratio is 6.293) supporting 
twin deficits hypothesis for U.S. Undoubtedly, this observation further supports the 
theoretical view of omitting two important variables viz. private saving, and investment in 
testing twin deficits hypothesis (see Cavallo, 2005).  
 
4. Conclusion 6 
 
This study proposes an alternative testing framework to the twin deficits hypothesis from the 
general equilibrium perceptive, in which both private savings and investments are included.   
Empirical illustration of using U.S. data shows supportive evidence of the twin deficits model 
derived from general equilibrium perceptive.  The budget deficit elasticity decreases (almost 
half) when the general equilibrium approach applied. It supports the argument made by 
Cavallo (2005). And, this study suggests an alternative framework for twin deficits 
hypothesis for further research 
 
 
 
 
 
 
 
 
 
 
 
 
References 
Bachman, D.D. (1992). Why is the US current account deficit so large? Evidence from vector 
autoregressions. Southern Economic Journal, 59, 232-240. 
 
Cavallo, M. (2005). Understanding the Twin Deficits: New Approaches, New Results, 
FRBSF Economic Letter Number 2005-16, July 22, 2005.  
 
Darrat, A. F. (1988). Have Large Budget Deficits Caused Rising Trade Deficits? Southern 
Economic Journal, 54, 879-886. 
 
Leachman, L.L., & Francis, B. (2002). Twin deficits: apparition or reality? Applied 
Economics, 34, 1121-1132. 
 
MacKinnon, James G., Haug, Alfred A. and Michelis, Leo (1999). Numerical distribution 
functions of likelihood ratio tests for cointegration, Journal of Applied Econometrics, 
14, 563-577 
 
Mendoza, E. G., Quadrini, V. and Rios-Rull, J.-V. (2007). Financial Integration, Financial 
Deepness and Global Imbalances. National Bureau of Economic Research (NBER) 
Working Paper No. 12909. 
 7 
 
Obstfeld, M. and Rogoff, K. (2005). Global current account imbalances exchange rate 
adjustments. Brookings Papers on Economic Activity, 1, 67–146 
 
 

Global current account imbalances exchange rate adjustments.

Have Large Budget Deficits Caused Rising Trade Deficits?

Numerical distribution functions of likelihood ratio tests for cointegration,

Twin deficits: apparition or reality?

Understanding the Twin Deficits: New Approaches, New Results,

Why is the US current account deficit so large? Evidence from vector autoregressions.

General Equilibrium Perception on Twin Deficits Hypothesis: An Empirical Evidence for the U.S.

http://www.buseco.monash.edu.au/eco/research/papers/2009/0909equilibriumtanglau.pdf

General Equilibrium Perception on Twin Deficits Hypothesis: An Empirical Evidence for the U.S.

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