Research

While the Twin Deficits view argues that a positive shock to government spending deteriorates net trade flows and appreciates the real exchange rate (RER), the literature has documented mixed evidence and lacks a theory that reconciles the cross-country heterogeneity. I propose a unified framework to study the dynamics of fiscal deficits, net trade flows, and asset prices. The theory relies on the fiscal rule, portfolio frictions, and capital-intensive trade. When increases in spending are financed with debt, the presence of portfolio frictions triggers deviations from the uncovered interest parity that depreciates the RER and heightens the crowding-out of investment. The presence of capital-intensive trade generates a sizable and persistent improvement in net trade. These predictions rationalize identified impulse responses to US government spending shocks. On the other hand, the theory predicts that the absence of debt-financed spending generates a deterioration of net trade and an appreciation of the RER. Using Panel data, I provide evidence consistent with the role of the fiscal rule in governing the external adjustment, helping to rationalize the puzzling evidence documented in the literature.

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.