The relationship between fiscal policy and the current account
has long attracted interest among academic economists and policymakers
after introduction of the standard intertemporal model of the current
account by Sachs (1981) and its extension by Obstfeld and Rogoff, (1995)
in open economy macroeconomics. There are two major strands of the
current account literature Mundell-Fleming [Mundell (1968) and Fleming
(1967)] and Ricardian equivalence [Barro (1974, 1989)] to explain such
variations in the deficits. According to Mundell-Fleming model budget
deficits cause current account deficits through stimulating income
growth or exchange rate appreciation [Darrat (1988); Abell (1990);
Bachman (1992) and Bahmani-Oskooee (1992)]. On the other hand, there is
Ricardian view that the financing of budget deficits, either through
reduced taxes or by issuing bond does not alter present value wealth of
private households since both temporarily reduced taxes and issuance of
bonds represent future tax liabilities [Kaufmann, et al. (2002); Evans
(1989); Miller and Russek (1989); Enders and Lee (1990) and Kim (1995)].
The underlying reason is that the effects of fiscal deficits on the
current account depend on the nature of the fiscal imbalance. For
example, in a simple theoretical model in which Ricardian equivalence
holds, a cut in lump sum taxes and the ensuing fiscal deficit would not
affect the current account as the private savings increase will offset
the fiscal deficit but investment will be unchanged. Conversely, a
transitory increase in government spending will increase both the fiscal
deficit and the current account deficit, a case of twin deficits. And a
permanent increase in government spending will have no effects on the
current account while its effects on the fiscal balance will depend on
whether the extra spending is financed right away with taxes (in which
case the fiscal balance is unchanged) or whether it is financed with
debt (future taxes) in which case the fiscal balance worsens. Thus,
fiscal deficit may or may not lead to current account deficits depending
on the nature and persistence of the fiscal shock. There is also a third
scenario relate to Recardian view that portrays the possibility of
negative relationship between the deficits where, for example, output
shock give rise to endogenous movements and two deficits are
divergent.
An Empirical Test on the Validity of China’s Fiscal Policy ——Based on the Ricardian Equivalence Proposition
