Budget deficits and current account balances: A theoretical and an empirical investigation of their links in the United States and the United Kingdom

This dissertation addresses issues related to the link between budget deficits and current account imbalances in the United States and the United Kingdom. A series of unrestricted vector autoregression (VAR) models are designed to represent alternative theories through the selection of variables and orderings. Granger-causality tests for block exogeneity as well as variance decompositions and impulse response functions with confidence bands are used to test the hypotheses. All estimations use quarterly data for the period 1975-1990. This dissertation finds a relatively weak link between the budget and current account deficits in the U.S., especially after controlling for other variables. The effect of the budget balance on the current account balance in the U.K. is mostly insignificant and often in the wrong direction. Interest rates are found to affect the current account balance in the U.S., mostly through the indirect effect of higher interest rates in inducing an appreciation of the dollar. The current account balance is significantly affected by its own innovations in both countries, and by exchange rates in the U.S. and the saving rate in the U.K. The Ricardian Equivalence Hypothesis (REH) is tested using a neoclassical VAR model. Different versions of neo-Keynesian models are also tested for both the U.S. and the U.K. While the U.S. data are more consistent with general neoclassical models than with the REH, the U.K. data are partly compatible with the REH. The U.S. data are also partly consistent with a neo-Keynesian model of a large country with capital mobility and a flexible exchange rate, while the U.K. data are partly consistent with a Mundell-Fleming model of a small country with a fixed exchange rate. For both countries, it is found that the omission of petroleum prices in the model does not bias the results for the effects of fiscal policy. The real petroleum price does significantly affect the current account balance in the U.K., but not in the U.S. Finally, for both countries, the current account balance has a minor effect on the budget deficit.