Problems with Fiscal Deficit 

When the government spend money unproductively which as a result:

• Lowers savings which negatively impacts growth 

• High government expenditure encourages inflationary pressures

• Results in currency depreciation 

 

Problems of Current Account Deficit 

• A negative CA suggests a country is a net creditor to the rest of the world and is likely indulging in excessive consumption, making an inefficient use of resources

• Leads to a net outflow of domestic currency, depleting currency reserves

• Currency depreciates as a result of low demand and risk of credit default 

 

Sustained twin deficits cause major implications for economic performance. The popular belief among economists is that large budget deficits are correlated to large CA deficits. This is because government tax cuts that reduce government income (fiscal policy), result with an increasing the budget deficit.  However, as a result, consumers now have higher disposable income which encourages increases in consumer spending; although if a country operated a CA deficit, the net effect of increased consumption will be negative as money will flow internationally to buy foreign goods for import. Furthermore, the trade-off is a decrease in national savings to the extent the country must begin to borrow from foreign lenders. 

 

Large fiscal deficits are known to crowd out private investment and stagnate economic growth. This is because increase in government expenditure requires 1) resources from the private sector and 2) borrowed funds. When this happens, the demand for loanable funds increases driving interest rates higher; further contributing to decreasing aggregate demand in the economy. Therefore, the net effect on GDP would be zero and  from the national income equation illustrates a reallocation of resources and not a contributing factor to eliminating the twin deficit. Although this assumes that the economy is at full employment. 

 

Contrary to Keynesian model; Ricardian Equivalence hypothesis (REH) states little correlation between budget and current account deficits and changing government tax structure has no impact on investment, rates or consumption. This is because consumption is assumed to be a function of lifetime income (long run) and short-term consumption choice are not well influenced by higher short-term disposable income. The popular consensus amongst households is that budget deficits are simply deferred taxation which consumers will eventually pay for. Therefore, REH suggests the tax cuts would only worse budget deficits and not improve the current account as private savings increase in anticipation for increased future tax. As such, if higher disposable income does not lead to increases in consumption, and it is saved, this reduces the need for borrowing thus reducing the likelihood of current account deficit. Both the twin deficit hypothesis and REH are well supported empirically, although findings vary amongst countries. 

 

The variance in findings could be a result of sample characteristics or different econometric techniques. A final explanation is that consumption choices are not linear i.e for every £1 increase in disposable income doesn’t necessarily equate to £1 in increase consumption, nor does the hypothesis specify the consumer utility bundles. Net Imports could diminish as disposable income increases as a result of consumer preferences switching to domestic goods; which would result in an imperfect correlation between the fiscal expansion effects and current account balance. Such discrepancies give merit to a rejection of the null.