Twin deficits hypothesis

In macroeconomics, the twin deficits hypothesis or the twin deficits phenomenon,[1] is the observation that, theoretically, there is a strong causal link between a nation's government budget balance and its current account balance.

This represents GDP because all the production in an economy (the left hand side of the equation) is used as consumption (C), investment (I), government spending (G), and goods that are exported in excess of imports (NX).

In this case, if the budget deficit increases, and saving remains the same, then this last equation implies that either investment (I) must fall (see crowding out), or net exports (NX) must fall, causing a trade deficit.

[3] If the country's own citizens' savings finance the borrowing, it may cause a crowding out effect (in an economy at or near potential output, or full employment).

In effect, the economy is borrowing from foreigners in exchange for foreign-made goods.

Traditional macroeconomics predicts that persistent double deficits will lead to currency devaluation/depreciation that can be severe and sudden.

In the case of the United States, the twin deficit graph as a percentage of GDP shows that the budget and current account deficits did move broadly in sync from 1981 until the early 1990s, but since then, they have moved apart.

Data thus confirm that as a government budget deficit widens, the current account falls, but the relationship is complicated by what happens to investment and private saving.

In the above equation, it is verifiable that CA will deteriorate as government expenditure exceeds the amount of tax is collected.

The equilibrium here is Saving + Net Capital Inflow = Investment + Budget Deficit.

However, taking the Forex market into consideration we know that the Trade Deficit is equal to Net Capital Inflow.