Do expenditure shocks affect GDP or trade balances in deficit-prone advanced economies?

This paper examines the short run relationship between domestic expenditure (or absorption), GDP, and the trade balance. It first presents a simple framework to illustrate how domestic expenditure shocks either directly impact national output or net exports. The more domestic spending affects the trade balance, the greater the independence between aggregate demand and supply. The paper then econometrically examines whether short run expenditure variation has translated mainly to GDP or trade balances for a group of trade deficit prone advanced economies – the United States, the United Kingdom, Australia, New Zealand, Ireland, Italy and Spain – from the turn of the century. The results provide strong evidence of very close correspondence between aggregate and disaggregated domestic spending, and trade balances in these economies. This is consistent with the classic Mundell–Fleming approach and intertemporal models of external account determination.