Threshold cointegration and the short-run dynamics of twin deficit behaviour

This paper examines the relationship between the current account and budget balances by means of a threshold cointegration approach advocated by Hansen and Seo (2002). Using US data covering 1947–2009, a long-run positive cointegrating relationship is confirmed. This supports the notion of a Keynesian twin deficits relationship. The short-run dynamics are investigated through an estimated threshold vector error correction model. Depending on the regime present, it is either the external or internal balance that is responsible for error correction. This has important implications for the use of fiscal policy to control the external balance.

Research highlights
► The relationship between the budget and current account deficits is estimated.
► Using US data, the results confirm the presence of threshold cointegration.
► The threshold itself is determined by the relative size of the two deficits.
► The vector error correction model indicates regime-specific adjustment dynamics.
► Fiscal policy is found to influence the current account in only one of two regimes.