Links Between the Fiscal Deficit and the Current Account Deficit

Question

Twin deficits refer to a situation where an economy is running both a fiscal deficit and a deficit on the current account of the balance of payments.

Explain the links between fiscal deficit and current account deficit. [10]

Answer

A fiscal deficit arises when government spending exceeds government revenue; a current account deficit arises when import expenditure (M) exceeds export revenue (X), so that the balance of trade is negative. The two are inherently linked, each capable of causing or worsening the other, so they tend to move together as “twin” deficits.

How a fiscal deficit worsens the current account. When the fiscal deficit worsens, the government injects more into the circular flow through higher government expenditure (G).

A worsening fiscal deficit raises government spending, shifting aggregate demand from AD₀ to AD₁ and raising national income from Y₀ to Y₁. Higher income raises disposable income and import expenditure, worsening the current account.

As G rises, aggregate demand rises from AD₀ to AD₁ and national income rises from Y₀ to Y₁, amplified by the multiplier. Firms facing an unplanned fall in inventories hire more factors of production including labour, so household disposable income rises. Higher disposable income makes consumers more willing and able to buy imports, so the quantity of imports demanded and hence import expenditure (M) rises. Assuming export revenue (X) is unchanged, the balance of trade worsens, causing or deepening a current account deficit.

How a current account deficit worsens the fiscal deficit. As the current account deficit worsens, the balance of trade $(X-M)$ deteriorates: consumers spend a larger share of income on imports rather than on domestic goods, and export revenue likely falls, so domestic firms earn lower revenue and profit. Firms cut output and employ fewer factors of production, reducing household disposable income. The fall in firms’ profits lowers the government’s corporate tax revenue, while the fall in disposable income lowers personal income tax revenue. Assuming government expenditure is unchanged, lower revenue worsens the fiscal deficit.

The two deficits are therefore mutually reinforcing: a larger fiscal deficit raises imports and worsens the current account, while a larger current account deficit erodes the tax base and worsens the fiscal balance — the mechanism behind the twin-deficits hypothesis.