Research

Working Papers

Twin Deficit's Redux: Government Purchases Dynamics and the International Adjustment  (JMP, draft coming soon) 

I propose a unified framework to study the dynamics of fiscal deficits, net trade flows and asset prices in advanced economies. I show empirically that increases in government purchases financed with debt that imply higher fiscal deficits, causes net trade to improve and the real exchange rate (RER) to depreciate, contrary to the twin-deficits view. I find that innovations to government purchases in the US account for 30 to 45 percent of the variation in US net trade and the RER. To explain these facts, I build a theory that relies on the fiscal rule that governs the response of government debt, the presence of portfolio frictions, and the intensity of trade in capital goods. In response to a positive shock to government purchases, the interaction of debt financed spending and portfolio frictions results in endogenous deviations from the uncovered interest parity that generate excess returns on home government bonds. This induces a strong crowding-out of investment, due to the no-arbitrage condition with debt markets, which is powerful enough to make domestic absorption fall. The RER depreciates so that expenditure switching operates and the excess of goods is exported to the ROW. The presence of trade intensive in capital goods generates a sizable and persistent improvement in net trade due to the fall in imports of this type of goods.

This paper studies the drivers of the US real exchange rate (RER), with a particular focus on its comovement with net trade (NT) flows. We consider the entire spectrum of frequencies, as the low-frequency variation accounts for 61 and 64 percent of the unconditional variance of the RER and NT, respectively. We develop a generalization of the standard international business cycle model that successfully rationalizes the joint dynamics of the RER and NT while accounting for the major puzzles of the RER. We find that, while financial shocks are necessary to capture high frequency variation in RER, trade shocks are essential for the lower frequency fluctuations.