International Macroeconomics HW 11

Prof Stephanie Schmitt-Grohe

Laurice Wong (lw2646@columbia.edu)

1.
a. Sources:
For Trade Deficit deduct “Imports of Goods and Services” from “Export of Goods
and Services” in BEA Table 4.1. For Fiscal Deficit, obtain from line named “Net
Government Savings” in BEA Table 3.1.

The article states that the US trade deficit has “widened to almost $1trn
annually”. This is false - most likely, the author is referring to the US goods
balance, which reached a deficit of $891bn in 2018. However, the trade balance
consists of a country’s import and export of both goods and services - and while
the US suffers a large deficit in its goods balance it benefits from a surplus in its
services balance. So the trade deficit is not as large as the author
claimed.However the author’s claim that the budget deficit will increase to over a
trillion is true for both 2017 and 2018.

Year US Trade Deficit (in billions of USD) US Fiscal Deficit (in billions of USD)

2016 -520.5 -926.3

2017 -578.4 -1,048.5

2018 -625.6 -1,265.2

b. The author probably means financial account when he refers to the capital
account - since CA = - FA. In that case, he is correct in saying that since the US
has to finance its budget deficit with lending from foreign nations, the FA
increases; correspondingly, the CA deteriorates (under a floating exchange rate).
c. Twin deficit hypothesis argues that fiscal deficits cause current account deficits.
The author subscribes to the twin deficit hypothesis because he lists Trump’s
budget policy to be the main reason why he thinks US’s trade balance will further
deteriorate. He argues that the Trump administration's “unfunded tax cuts” will
reduce the US’s savings levels and increase its investment level; this forces the
Fed to raise interest rates to keep the US economy from overheating. When
interest rates are relatively high, the US dollar strengthens, making it harder to
export (US goods are relatively expensive ) and easier to import from other
countries. As a result, the trade deficit widens.
d. Under covered interest rate parity, low interest rate currencies must be trading at
a premium in the forward market. As Europe and Japan central banks keep their
interest rate low comparative to the US, the euro and the yen should be trading at
a premium in the forward market. It also follows that eventually the euro and the
yen will appreciate to the amount to interest rate differential between the US and
EU/ Japan respectively, although historical data has shown that the appreciation
International Macroeconomics HW 11
Prof Stephanie Schmitt-Grohe
Laurice Wong (lw2646@columbia.edu)
is consistently less than the interest rate differential. That being said, according to
the forward premium puzzle, eventually the strength of the US dollar should
diminish, so in the long run the trade deficit will not widen even given the
difference in interest rate policy between the Fed and EU/ Japanese central
banks.
e. See attached after this page.
f. The author does show how Trump’s economic policies can lead to both trade and
budget deficits, and shows how the two can be correlated (as argued under the
Twin Deficit Hypothesis). However, the author does not show why the emergence
of the twin deficit is a problem/ debilitating - rather, he just assumes that having a
trade deficit and/ or a budget deficit is inherently bad. However, this is not true -
as long as the trade deficits and budget deficits are not caused by structural
economic issues and the country’s economic performance can service its
external debt, there is no reason why these deficits are inherently a “crisis” or a
problem.