FISCAL-POLICY AND TRADE ADJUSTMENT - ARE THE DEFICITS REALLY TWINS

Since the mid 1980s, an extensive empirical literature has examined the relationship between U.S. fiscal deficits, exchange rates, and trade balances. We investigate two questions that continue to spark debate: do increased government deficits cause dollar appreciation, and do fiscal deficits lead to higher trade deficits (the popular 'twin deficit' notion)? We examine these issues using a five-variable VAR system, generating posterior probability bounds to assess significance. Our results provide some evidence that growing government deficits appreciate the dollar, and support the ''twin deficit'' notion that government deficits contribute to trade deficits.