Question

Weigh the pros a nd cons b 94 1s the government budget deficit of a countr linked to its current account balance? How so? Explain how it is possible for the United States' current account deficit to grow while the budget deficit has disappeared, as hap- pened in the 1990s.

Answer 1

Budget deficit of a country is linked to its current account deficit. Also known as twin deficits hypothesis, it states that there is a causal relationship between government budget balance and current account balance.

Budget deficit (also called fiscal deficit) happens when a country's expenses exceed its revenue income. Deficit spending can be useful for jumpstarting the economy especially when economy is experiencing a recession as it helps in financing infrastructure projects which result in purchase of materials and hiring of workers. As a result, workers spend money and boost the economy.

Current account deficit occurs when a country imports more than it exports. Also, called trade deficit, current account deficit could be bad in a recession but can be helpful when the economy is the phase of expansion.

Most economists believe that a large budget deficit is related to a large current account deficit and vice versa because as the government cuts taxes, there is a reduction in revenue and increase in deficit and increase in consumption because consumers can spend more due to reduction in taxes. Increase in consumption will reduce the national savings rate which will cause the nation to increase the amount of borrowings from abroad. However, there is no static relationship betweeen the two as can be seen in the case of US as well

In case of United States, even though the budget deficit has stayed in control but current account deficit is huge because American consumers spend more on imported goods and services than US businesses export to other countries. Current account deficit might have increased and budget deficit disappeared because US invests a lot in other countries which is not included in the budget, hence it doesn't show up in the budget deficit.