Corsetti and Müller’s
“Twin Deficits:
Squaring Theory, Evidence and
Common Sense”
Frank Warnock
Darden Business School, University of Virginia
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Basic Theme
 Fiscal expansions have no effect on trade balance if
 The economy is not open to trade
 Fiscal shocks are not too persistent
 With home bias, fiscal shocks drive wedges between
 returns on domestic and foreign investment
 r and r*
 The wedges impact investment decisions and
eventually the trade balance
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Mechanism
 G falls on home goods, P goes up, and we get a
lasting terms of trade appreciation.


returns on domestic investment increase
r also increases
 Case 1: Stronger home bias
 reduced impact of t on the return to capital
 increased r-r*
 Case 2: More open economies
 fiscal shocks improve return to capital
 muted impact on r-r*
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Mechanism
 So the mechanism is through price changes
which then impact quantities.
 Evidence?
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Evidence on Quantities
 Consistent with the model
 In the relatively open countries (UK and CA), fiscal
loosening results in a trade deficit but has little impact
on investment.
 In the relatively closed US, fiscal loosening has no
impact on trade balance and results in a decline in
investment.
 Less consistent with the model
 In the moderately closed AU, fiscal loosening has no
impact on trade balance or investment.
 Evidence on prices?
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Evidence on Prices
 Inconsistent with the model


Responses of inflation and interest rates are
positive or negative depending on the horizon
Terms of trade generally tend to depreciate
 “Further analysis is needed to understand the
response of inflation, the interest rate, and
the terms of trade.”
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Where does this leave us?
 Theory stresses the role of prices.
 Empirical evidence on prices is not
supportive.
 “Further analysis is needed…”
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Bottom Line
 Interesting, well-executed paper.
 We have known that there isn’t a direct link
between trade and budget deficits, but
Corsetti and Müller teach us about the roles
of openness and fiscal persistence.
 I’d like to better understand the role of prices
in this analysis.
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