Effects of monetary policy on the twin deficits

Abstract

This study uses a three-equation dynamic linear system to show the positive relationship between federal budget deficits and the 5-year Treasury bond rate and between the twin deficits in the U.S. during 1975:01 through 2004:12. An optimal efficient rule equation suggests that a one percentage point increase in bond rate explains a 22% budget deficit variations. A one index point change in nominal exchange rate correlates to a 78% variation in budget deficits. When real exchange rate is adopted in the system, the corresponding percentages become 14 and 86, respectively, showing the fading influence of T-bond rate and the increasing strength of exchange rate. © 2006 Board of Trustees of the University of Illinois.