Material Covered

1. National Savings Identity (NSI) and the Twin

Deficits
2. Characteristics of a Safe Haven Economy-
Classroom Discussion and Video
3. Benefits of a Safe Haven Economy- Classroom
Discussion and Video
4. Discussion of Caselet linking Fiscal Policy and
BoP

slide 1
Linking the Twin Deficits
▪ Coming back to the National Savings Identity, we now
explore how the budget and current account balances
may be linked by the NSI expression:
Y=C+I+G+(Exp-Imp) -------------(1)
Y= C+S+T --------------------------(2)
(G - T) = (S - I) + (Imp - Exp). -----------(3)
▪ Assumption - deficits is bond-financed
▪ The left-hand-side of the NSI is in fact a demand for
borrowing, while the right-hand-side, in equilibrium,
constitutes a supply of lending.

slide 2
Linking the Twin Deficits

1. As the central government incurs a budget deficit that

has to be financed by borrowing (since we assume no
monetization here), the demand for loanable funds
increases
2. This increase in demand drives up domestic interest
rates to the higher equilibrium.
As interest rates of these safe haven domestic
government bonds exceed those of other countries,
domestic and foreign investors now "switch" to the
higher yielding and safe domestic government debt.

slide 3
Linking the Twin Deficits
3. This excess demand for domestic currency-US
dollars-makes this currency "more expensive" in
terms of foreign currency in the global foreign
exchange markets.
▪ That is, the domestic currency appreciates (gets
"stronger") relative to foreign currencies.
▪ A hypothetical example of US currency appreciation
would be:
▪ Before step (I) I US$ = 100 units of foreign currency.
▪ After step (I) I US$ = 120 units of foreign currency.

slide 4
Linking the Twin Deficits
▪ 4. With the strengthening of the domestic currency,
imports now become "cheaper" for domestic residents,
while domestic exports become more "expensive" to
foreign consumers who have to exchange more units
of their currencies for one unit of domestic currency.
▪ 5. Hence, as imports surge and as exports slow, the
current account balance (Exp-Imp) decreases and the
domestic budget deficit-incurring economy eventually
experiences a deterioration in its current account
balance.
▪ In this scenario, the "twin deficits" are indeed linked.
Here, the budget imbalance (G- T) drives the NSI
and, by influencing interest rates and exchanges rates,
results in a decrease in the current account balance
and perhaps eventually in a current account deficit.
slide 5
Linking the Twin Deficits
▪ 6. As the domestic economy amasses cheaper
imports, foreigners accumulate deposits of domestic
currency.
▪ For example, the US accumulates imports from Japan
and China, while these two current account surplus
countries amass massive dollar deposits.
▪ These dollar deposits are then promptly re-invested in
the safe haven, high yielding domestic economy (the
US, in this example).
▪ That is, the domestic economy incurs a current account
deficit but also experiences an inflow of capital-a
capital account surplus.

slide 6
Linking the Twin Deficits
▪ 7. Finally, because of the capital inflow, equilibrium
interest rates in the domestic economy are now
lowered to ilow. Capital inflows supplement domestic
savings (supply of loanable funds), and thereby exert
an important ameliorating influence on domestic
interest rates.
▪ 7.Almost 40-60% of the US deficit in the 1980s and
post-9/ll periods, and virtually 100% of US interest
expenses on government debt were funded by
massive capital inflows associated with the US
current account deficits.

slide 7
Linking the Twin Deficits

▪ A country incurring a current account deficit (loosely,

trade deficit) will also experience a capital account
surplus (net capital inflow).
▪ The capital account surplus and the current account
deficit are two sides of the same coin.
▪ This form of bond financing sounds extremely
convenient.
▪ The budget-deficit-incurring country experiences a
current account deficit but also benefits from capital
inflows that serve to keep interest rates lower at
home! How long is this sustainable?

slide 8
Sustainable" Bond Financed Deficit
▪ A "sustainable" bond financed deficit is defined as that
which can be rolled over perpetually by issuing additional
bonds when the current bonds come due.
▪ As long as the inflation adjusted (or "real") rate on
government bonds is less than the growth rate of the
economy, deficits are defined to be sustainable and the
NSI bond-financing model can be implemented with
impunity.
▪ A "non-sustainable" deficit, however, is that which has
exploded out of control and cannot be bond-financed any
longer; domestic and foreign investors refuse to absorb
any more of this government's debt in their portfolios. A
massive monetization becomes inevitable. Here, the real
interest on government debt exceeds the growth rate of
the economy.' slide 9
US-Type NSI
▪ We begin by plugging in some hypothetical
representative numbers for this class of economies, into
the NSI:
▪ (G - T) = (S - I) + (Imp - Exp) (1)
▪ Let (G-T) = (450), a significant budget deficit, and let
(Imp-Exp) = 500, a large current account deficit. (450) =
(S - I) + (500)
▪ Quite simply, (S-I) = (-50).
▪ This implies that private demand for loanable funds in
this economy outstrips the supply of domestic savings
by 50 billion US$. How is this shortfall in the supply of
loanable funds financed?
▪ Re-writing (1), we obtain:
▪ (Imp - Exp) = [(G - T) + (I)] - S (2) slide 10
 US-Type NSI
▪ (Imp - Exp) = [(G - T) + I] - S
▪ The first term on the right-hand-side, [(G- T) + (I)], is the
composite demand for borrowing, comprising government
demand (G-T) plus private demand, (I).
▪ S is the domestic supply of loanable funds.
▪ Once again, plugging in the numbers into the right-hand-side
of
▪ (Imp - Exp) = ((G - T) + I] - S = ((450) + 300] - 250 = 500
▪ Here, the current account deficit, or more specifically the
capital inflow associated with the current account deficit,
amounts to 500 billion US$. It is inflow of funds that finances
the shortfall in the supply of loanable funds.

slide 11
China-Type NSI
▪ Here, we let the hypothetical sustainable budget deficit be
(G-T) = 30, and the current account surplus is given as
(Imp-Exp) = -347. Substituting these values into the NSI,
we obtain: .
▪ (30) = (S - I) + (-347)
▪ Therefore, (S-I) = 377 billion US$.
▪ This is symptomatic of most economies in Southeast Asia
that are awash in domestic savings and, on net, are
"exporters" of global capital.
▪ Given the current account surplus in this example, the
outflow is computed to be 377 billion US$. One example of
"excess savings" has been the Chinese economy from the
mid-1990s to the present. In fact, in the record year 2002-
03, national savings rocketed by over 25% to $1.3 trillion!
slide 12