Twin deficits in the G-7 countries and global structural imbalances

According to open economy macroeconomics, a government budget deficit leads to a current account deficit. The link is as follows: a budget deficit leads to an increase in the real domestic interest rate; this attracts foreign capital and results in an appreciation of the domestic currency, which leads to a current account (imports plus net transfers abroad, minus exports) deficit. Thus, the entire current account deficit and part of the budget deficit is financed by a net capital inflow. This paper reviews and extends the theoretical analysis of the “twin deficits” and then confirms this relationship empirically for the G-7 countries over the past three decades.