Twin Deficits, Openness, and the Business Cycle

In this article, we study the co-movement of the government budget balance and the trade balance at business-cycle frequencies. In a sample of 10 OECD countries we find that the correlation of the two time series is negative, but less so in more open economies. Moreover, for the U.S. the cross-correlation function is S-shaped. We analyze these regularities taking the perspective of international business cycle theory. First, we show that a standard model delivers predictions broadly in line with the evidence. Second, we show that conditional on spending shocks the model predicts a perfect correlation of the budget balance and the trade balance. The effect of spending shocks on the trade balance is contained, however, if an economy is not very open to trade. (JEL:F41, F42, E32) (c) 2008 by the European Economic Association.