The U. S.

Budget and Trade Deficits: A Simultaneous Equation Model

Author(s): Joachim Zietz and Donald K. Pemberton
Source: Southern Economic Journal, Vol. 57, No. 1 (Jul., 1990), pp. 23-34
Published by: Southern Economic Association
Stable URL: http://www.jstor.org/stable/1060475
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The U.S. Budget and Trade Deficits:
A Simultaneous Equation Model*
JOACHIM ZIETZ
Middle Tennessee State University
Murfreesboro, Tennessee

DONALD K. PEMBERTON
University of Detroit
Detroit, Michigan

l. lntroduction

The large and apparently persistent U. S. trade deficit has sparked a considerable amount of re-
search into its determinants and the proper policy responses. At least two key questions can be
identified in this context, a general one and a more specific one. First, to what extent can the trade
deficit be explained by changes in macroeconomic fundamentals as opposed to microeconomic
explanations, such as quality deterioration of U. S. goods and the like? Second, to what extent and
through which channels does the federal budget deficit affect the trade deficit, if at all?
Most recent macroeconomic studies on the U.S. trade deficit have focused on mono-causal
explanations in the single-equation semi-reduced form framework. 1 One major thrust of this re-
search has examined the link between the budget deficit and the trade deficit that may operate via
higher interest rates and the resulting appreciation of the exchange rate. Recent examples of this
type of work include Hutchison and Throop [ 14] and Evans [8]. Few studies have focused on more
traditional macroeconomic links, such as the differences in the relative growth rates of domestic
demand and income between the U.S. and its major trading partners. One notable exception is
Krugman and Baldwin [18], who conclude that slow demand growth overseas compared to the
U.S. can explain a sizable share of the trade deficit, independently from what can be attributed to
movements of the exchange rate. They do not isolate, however, the impact of the budget deficit
on domestic demand and the trade balance.
The purpose of this paper is to extend the existing literature by providing an answer to two
related questions. First, what role, if any, has the federal budget deficit played for the trade defi-
cit? Second, what has been its impact on the trade deficit relative to factors such as slow income
growth abroad? The analysis employs a structural simultaneous equation framework. This ap-
proach has the advantage of allowing, in explicit form, for a number of altemative channels of

*The authors wish to thank the referee for severa! helpful suggestíons. The usual disclaimer applies.
l. Altematíve approaches based on large macroeconomic models are summarized, for example, in Bryant and
Holtharn [5].

23

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24 Joachim Zietz and DoiUlld K. Pemberton

transmission between the twin deficits. 2 Rather than pre-judging the relative importance of any
one of these transmission channels based on theoretical reasoning alone, the data are given a
chance to identify their empirical relevance.
The paper is organized as follows. Section 11 introduces the theoretical framework. Next, we
describe the data base and report the estimation results. Section IV contains the evidence from
sorne policy simulations on the estimated model. Section V sumrnarizes and concludes the paper.

11. The Theoretical Framework

We consider a simple open-economy macroeconomic model comprised of bond, foreign ex-

change, and goods market. The bond market determines the interest rate (r). lts equilibrium level
is found as the solution to the bond market equilibrium condition

S(r ,ms,pe,df,y) =D(r ,k ,pe,y ),

+ + + +-- -
where S and D stand for supply and demand of bonds, respectively, ms for the money supply,
k for the cumulated balance on current account, 3 pe for the expected infiation rate, df for the
federal govemment budget deficit, and y for gross national product. The expected signs of the
partial derivatives appear undemeath the variables. Most require little explanation; an exception
may be the sign of k. As the U. S. runs a current account deficit and foreigners accumulate dollar
denominated claims on the U.S. prívate sector, k diminishes,4 while the demand for U.S. bonds
rises. The money supply is a function of the monetary base (mb) and the interest-dependent
money multiplier. Solving the above bond market equilibrium condition for the interest rate (r),
leads to the estimating equation

r = r(y ,pe,mb,k ,df) (1)

+ + - + +
for interest rate r. 5
The determining equation for the foreign exchange rate is based on a portfolio-balance model
developed in sorne detail in Boughton [3]. Recently, it has been tested quite successfully against
a number of competing exchange rate equations [4]. The exchange rate equation has three distin-
guishing characteristics. First, relative money supplies do not affect the exchange rate directly, 6

2. This approach follows a suggestion of Darrat [6], who found a high degree of simultaneity between interest
rates, exchange rates, and budget and trade deficit. Also see Isard [15] on the need to frame the analysis in a simultaneous
equation model.
3. As foreign investors display a marked preference for short-term as opposed to long-term dollar assets, their
investment behavior is likely to have a direct influence only on short-term interest rates. Empírica! evidence for this is
provided by Hoelscher [13, 11].
4. This follows from the balance of payments constraint, which implies that the reduction in k has to be matched
by a reduction in foreign currency assets held by the U.S. private sector, by a decrease in the Federal Reserve's hold-
ings of foreign assets, or by an increase in holdings by foreigners of U.S. bonds, or more generally, U.S. credit market
instruments.
5. lt may be noted that sorne empírica! evidence [14; 10] suggests that new information on expected budget defi-
cits is disseminated quickly in asset markets so that the expected rather than the actual budget deficit would appear in
equation (1).
6. There is increasing empírica! evidence that relative asset supplies do not provide a satisfactory account of
exchange rate movements. See, for example, the recent study by Frankel [11].

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 U.S. BUDGET AND TRADE DEFICITS 25

but only indirectly via the interest rate, income, and the inflation rate. Second, the real interest
rate differential determines the rate of change of the exchange rate rather than its level, thereby
allowing the exchange rate to change even for a constant interest differential. Third, cumulating
current account deficits and hence U.S. foreign indebtedness (falling k) is predicted to lead to a
depreciation of the U.S. dollar as foreigners try to avoid capitallosses from a sudden depreciation
of the dollar in the face of unsustainable current account deficits. 7 Following Boughton [4], the
estimating equation for the exchange rate can be written as

dlne = e[(r- p)- (r- p)*,k ], (2)

+ +

where d ln stands for the first differences in the naturallogarithm and where the asterisk indicates
a foreign country variable.
The model is completed by the goods market equations. Domestic absorption, that is the
sum of personal consumption, investment, and govemment expenditures, is assumed to depend
on income, the real interest rate, and a number of other variables. Following the work by David-
son et al. [7] on prívate consumption, the inflation rate (jJ) is included among the determinants of
absorption. The monetary base is intended to capture the effect on q of money induced liquidity
and wealth effects in consumption as well as the influence of money on investment that oper-
ates via credit rationing and stock price changes. Finally, the federal budget deficit (df) serves
as a summary indicator of the impact of tax, expenditure, and transfer policies of the federal
govemment,

q = q(y , i - p,p ,mb,df). (3)

+ - + +

Income is identically equal to the sum of absorption and net exports (y = q + x - m). Exports
(x) and imports (y) are determined by the real exchange rate (e) and domestic and foreign income
(y*) in the traditional way, as

x = x(e ,y*) and m= m(e ,y). (4)

- + + +

The inflation rate is assumed to depend positively on the ratio between actual and potential ab-
sorption (a gap) and on the degree of export dependence, as measured by the share of net exports
in gross national product. A rising share of net exports is predicted to raise the rate of inflation.
Conversely, a high degree of import competition is assumed to lower the inflation rate,

p = p[agap, (x - m)/y]. (5)

+ +

The theoretical model allows for three transmission channels between the budget deficit and
the current account. The first channel operates directly via bond market (r) and exchange rate. It
requires positive signs for the budget deficit variable in equation ( 1) and for the real interest rate
variable in equation (2). Channels two and three both rely for their initial impact on a positive

7. With an x-percentage point interest rate differential in favor of U. S. assets, holders of U. S. bonds are as well
off as holders of foreign bonds only if the dollar is expected to depreciate at a rate of x percent or less per year.

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26 Joachim Zietz and Donald K. Pemberton

sign of the partial derivative qd¡ 8 in the domestic absorption equation (3). Channel two, the link
via the capital account of the balance of payments, depends for its operation, in addition, on
positive signs for the partial derivatives iy and d ln(e); in equations (1) and (2), respectively. The
third transmission channel, that is the one via the current account of the balance of payments, is
conditional on my > O in equation (4). It is also the link at the heart of the traditional "Keynesian
aggregate-demand" or "absorption" approach as developed by Meade [20], Alexander [ 1], and
Johnson [16].
The extent to which changes in foreign income affect the domestic economy depends on
the size of the partial derivative Xy•. Whatever its size, however, any exogenous rise in exports
induces, via the income identity, a rise in income and absorption, thereby partially mitigating the
initial improvement in net exports.

111. Data and Estimation Results

The model is estimated on quarterly seasonally adjusted data. All value terms are expressed
in 1982 U.S. dollars. Table 1 contains the variable definitions and sources. The sample covers
the period from 1972:4, the advent of ftoating exchange rates, to 1987:2, a few months before
the stock market crash of 1987. The model's six behavioral equations, as given by equations
(1) through (5) in the previous section, are estimated by two-stage least squares. Along with all
other model equations, they are collected in Table 11. Based on R 2 criteria, most of them have a
fairly good fit and, judging by the test statistics for first-order autocorrelation (7T), none shows
any apparent sign of misspecification. 9
Compared to the theoretical model detailed in the last section, the estimated model equa-
tions of Table 11 show sorne changes as mandated by the data generating process of sorne of the
endogenous variables. These include, inter alia, the specification of numerous polynomial distrib-
uted lags or other simpler lag structures .10 The estimated mo del of Table 11 includes two interest
rate equations, one explaining the treasury bill rate (r), and another expressing the commercial
paper rate (i) as a function of the t-bill rate. The t-bill rate provides a superior fit in the exchange
rate equation, the commercial paper rate in the domestic absorption equation. Using two interest
rate definitions also improves the model's overall performance in dynamic simulations.
The estimating equation for r now includes an interaction term between the monetary base
and a dummy variable (d). The interaction term allows the coefficient of the monetary base to
vary over time to account for the period of pure money supply targeting by the Federal Reserve
during the early eighties. Inftation expectations are approximated by a polynomial distributed lag.
Experimentation with variable df, its expectation and, altematively, with the actual budget deficit
or its expectation did not result in estimates that were both statistically significant and theoreti-
cally plausible on average." Due to the fragility of the association between budget deficit and

8. Yx represents the partial derivative of y with respect to x.

9. The test statistic 7T for first-order serial correlation is the one suggested by Godfrey [12] for dynamic simulta-
neous equation models. For a one-sided test, 7T follows the standard normal distribution.
10. All polynomial distributed lags are estimated without endpoint constraints. Lag order and lag length are chosen
so as to maximize R 2 •
11. Sorne experimentation revealed that the theoretically expected positive association between budget deficit and
r depended critically on the chosen sample period. This was the case regardless of whether the actual or the structural
budget deficit was employed.

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 U.S. BUDGET AND TRADE DEFICITS 27

Table l. Variables: Definitions and Sources

agap Ratio of actual to trend value of (q), see Table 11

cd Dummy variable for credit rationing, unity from 1980:2 to 1980:3
d Dummy variable for Federal Reserve targeting of money supply, unity from 1979:4 to 1982:3
ddm Dockstrike dummy variable for imports (MPS-JDOCKIM)
ddx Dockstrike dummy variable for exports (MPS-JDOCKIX)
df Real structural deficit, defined as expenditures minus tax revenue; up to 1974:2 based on
"middle expansion trend", series from 1974:3 onward based on "6 percent unemployment rate
trend GNP" (Survey of Current Business, March 1986, August 1987, May 1988)
e Real trade weighted exchange rate, Federal Reserve Bank of Dalias (RX 101)
fs Relative foreign supply (MCM-URFSUP)
4-6 month commercial paper rate (MPS-RCP)
k Cumulated real balance on goods and services, set toO in 1970:2; see Table 11
m Real imports of goods and services (N/A)
mb Nominal monetary base (MPS-MB$)
nxy Ratio of net exports to GNP; see Table 11
p Infiation rate at annual rate, constructed from GNP price defiator (N/A)
pm Annualized percentage change of U.S. unit value index of petroleum imports (MPS-PEMP)
q Sum of real consumption, investment, and govemment expenditures; y - x + m
qf Fitted values from time trend regression of domestic absorption (q); see Table 11
r 3-month treasury bill rate (MPS-RTB)
time Time trend, with O in 1970:1
x Real exports of goods and services (N/A)
y Real gross national product (N/A)
y* Real foreign income (MPS-FGNPMW)
All real variables are expressed in 1982 dollars. MPS stands for the MPS-model data base, MCM for the Federal
Reserve's Multi-Country Model database, and NIA for the Nationallncome and Products Accounts. Variable identifiers
are provided in parentheses for all variables taken from the MPS and MCM models of the Federal Reserve.

Table 11. Model Equations

T-Bill Rate

r= -14.6 - .032mb + .014mb · d + .0073y - 2.7cd + .002k + .22p + .072p"! 1 + .47r -J

(-4.1) (-2.6) (4.0) (4.3) (-3.8) (3.1) (2.6) (1.6) (4.7)

R 2 = .9061 7T = .95 SE= .906

Commercial Paper Rate

i=.74 + 1.03r rho = .66

(1.6) (19)

R 2 = .8649 7T = -.03 SE= .549

Real Trade-Weighted Exchange Rate

e=7.7 + .3l(r- p) + .93e-¡ + .0023k

(2.9) (3.7) (32) (3.0)

R 2 = .9652 7T = .55 SE= 1.86

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28 Joachim Zietz and Donnld K. Pemberton

Table 11. Continued

Domestic Absorption

q=227 -10.52;~(i -fi)-¡ + .932:~Y-i -17.72:~P-i + .942;¿mb-¡ + .532;gdf-¡- 55.6cd

(2.6) (-3.9) (21) (-7.5) (1.8) (2.8) (-5.2)

R 2 = .9993 7T = -.42 SE= 11.1

Exports of Goods and Services

x=-750 + 2.36y*- .962;Óe-¡ + 2.52;Ófs-¡ + 324ddx + .08(y- Y-d + .83x-l

( -4.5) (3.8) ( -4.0) (5.1) (2.3) (2.2) (10)

R 2 = .9899 7T = -.49 SE= 6.14

Imports of Goods and Services

m=-362 + .17y - .06Y-4 + .862;6e-¡ + 89ddm + .51m_l

(-2.0) (7.3) (-3.4) (3.6) (.5) (5.7)

R 2 = .9878 7T = .81 SE= 10.3

Domestic Inflation Rate

p=-36 + +43.2agap+121.7agap·nxy+.932:~P~¡
(-5.3) (6.4) (9.9) (6.4)

R 2 = .7771 7T = .42 SE= 1.44

Trend Domestic Absorption (total)

qf=2692- .1122time + .261time2

(36) (- .03) (5.1)

R 2 = .9795 SE= 101.6

ldentities

y=q+x-m
k=k-1 +x-1-m-1
agap = q/qf
nxy = (x - m)/y

T-statistics are reported in parentheses. 7T stands for Godfrey's [12] test for serial correlation in dynamic simulta-
neous equation systems. SE is the standard error of the regression.

r, the interest rate equation was finally estimated without including df or its expectation. As a
result, the budget deficit can affect net exports only vía domestic absorption, not vía a direct link
to interest rate and exchange rate. Hence, the first transmission channel outlined in the previous
section is not operative in the estimated model.
The exchange rate equation contains only the domestic not the foreign interest rate. Ex-
periments with various altemative more comprehensive definitions of the interest rate term led

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 U.S. BUDGET ANO TRADE DEFICITS 29

Table 111. Criteria for Goodness of Fit of Simulation Model

THEIL'S U
MEAN
CORR RMSE MAE Value Bias Variation 1981-87
.839 1.65 1.33 .086 .037 .003 9.05
(i- p) .898 1.50 1.22 .179 .000 .010 2.58
r .843 1.57 1.32 .090 .028 .003 8.12
(r- p) .890 1.55 1.26 .212 .001 .016 1.65
e .944 3.55 2.93 .019 .128 .011 96.24
p .841 1.60 1.28 .112 .037 .032 6.47
q .989 57.2 46.7 .009 .014 .068 2927.6
y .989 51.7 41.7 .008 .061 .004 3154.2
X .979 15.9 13.7 .024 .179 .253 329.3
m .987 14.5 11.7 .020 .003 .087 355.5
(x-m) .945 20.4 17.0 .166 .084 .063 -26.2
k .877 157.8 122.8 .106 .002 .056 -669.7
CORR-correlation coefficient of actual and simulated series; RMSE-root mean squared error; MAE-mean ab-
solute error; THEIL'S U-Theil's Inequality Coefficient [22, eq. (5)]; Value-value ofTheil's U; Bias-fraction of error
dueto bias; Variation-fraction of error dueto different variation; MEAN-mean value of variable.

consistently toa worse fit of the equation. 12 This result suggests that foreign interest rates have not
been truly exogenous, as often assumed, but highly correlated with the corresponding U.S. vari-
ables. The most likely scenario is that foreign interest rates have been set by foreign central banks
with the aim to maintain a certain desired exchange rate vis-a-vis the U.S. dollarY However, if
foreign interest rates can be modeled as a linear function of U. S. interest rates, e.g.,

(r- p)* =a+ {3(r- p),

then the interest rate differential is a simple function ofthe U.S. interest rate alone, i.e.,

(r- p)- (r- p)* =-a+ (1- {3)(r- p).

lt may also be noted in this context that the functional form as given in Table 11 proved to be
superior in dynamic model simulations to the form in logarithms as suggested by Boughton [4]. 14
The equations representing the goods market are amended by a number of dummy and other
variables. For example, relative foreign supply (j s ), a variable from the Federal Reserve's Multi-
Country Model, tumed out to be statistically significant in the export equation. Adding the change
in domestic income also improved the fit ofthe export equation. The oil import price index tumed
out to be highly significant in the price equation.
Before discussing the policy simulations, it is of interest to check the fit of the complete
model as given in Table 11. The pertinent results of an historical simulation over the full sample
period are collected in Table III. Theil's inequality coefficient (U) exceeds the value of 0.1 for
only one base variable (p), that is a variable for which a separate equation has been estimated.

12. Also compare Meese and Rogoff [21] on this.

13. This behavior of foreign central banks is incorporated in a formal exchange rate model by Boughton [3].
14. A PE test for linear versus log-linear functional formas suggested by MacKinnon, White, and Davidson [19]
proved inconclusive.

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30 Joachim Zietz and Donald K. Pemberton

The other variables with large U values (net exports and the two real interest rates) are functions
of several base variables, for which the error cumulates. The decomposition of Theil's inequality
coefficient in Table III identifies only three variables for which the systematic error 15 exceeds lO
percent of the total error. These three variables are the real exchange rate (e), gross exports (x),
and net exports. All three variables and their systematic errors are highly interdependent in the
model. Closer inspection uncovered that the systematic errors result to a large extent from the
model's inability to fully capture the strong appreciation ofthe real exchange rate between 1984:3
and 1985:3. 16

IV. Results of Policy Simulations

To identify the impact on U. S. net exports of federal govemment budget deficits and foreign in-
come growth, two separate policy simulations are conducted with the model of Table 11. The first
one is intended to isolate the economic consequences of the large U.S. govemment budget deficit
of the eighties, the second one the impact of relatively sluggish foreign income growth during the
same time period.
The budget deficit simulation assumes that the structural federal govemment budget deficit
(df) would have remained at its 1981 level for the period from 1981:1 through 1987:2. 17 In reality,
the deficit widened considerably after 1981 (Figure 1). In fact, it reached a record $180 billion
before it started to diminish somewhat in late 1986. Hence, setting the budget deficit constant at
its 1981 level assumes a considerable shift in federal budget policy. Although the model is silent
about how the structural budget deficit could have been kept at roughly $28 billion in 1982 dollars,
it appears certain that it would have required a combination of foregoing tax reductions, restrain-
ing the growth of federal govemment expenditures, and curbing the surge in transfer payments,
in particular those related to entitlement programs .18 The predicted effect of such a stringent fiscal
policy on net exports is depicted in Figure l. The model suggests that net exports would have
exceeded actually realized net exports by close to $40 billion in early 1986. In fact, Figure 1
reveals a fairly strong association between the structural budget deficit and the predicted abso-
lute change in net exports. The larger the budget deficit grew after 1981, the more declined net
exports, and vice versa after 1986:2.
What would a lower budget deficit have meant for sorne of the other macroeconomic vari-
ables? For one, real income would have been 3. 3 percent lower by early 1987. Nominal interest
rates would have been lower, too. As depicted in Figure 2, the commercial paper rate (i) would
have been cut by almost 20 percent during the quarter of the largest budget deficit (1986:2).
Similar to the case of net exports, the movement of the commercial paper rate appears to be fairly
synchronized with that of the budget deficit. By contrast, the real exchange rate (e) follows a

15. The systematic error consists of the sum of the fraction dueto bias and the fraction dueto different variation
between actual and simulated series. The difference between this sum and unity is attributable to random variation.
16. Other authors [17] have noted before that the dollar's rise during this time period cannot be explained by a
change in economic fundamentals.
17. The average deficit for 1981 amounted to $28.2 billion in 1982 dollars. For the purpose of the policy simula-
tions, the variable df is assumed exogenous with respect to both interest rates, i and r. Neither interest rate proved to be
significant in a regression of df on tax rates and govemment expenditures.
18. In Figures 1 and 2 al! these policies are subsumed, for convenience, under the terrn "fiscal policy".

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 U. S. BUDGET ANO TRADE DEFICITS 31

60 10
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81:1 82:1 83:1 84:1 85:1 86:1 87 1

Note: --- fiscal policy; _ _ fiscal policy ond foreign incorne growth

Figure l. Structural Budget Deficit (df) and Effect ofPolicy Changes on Net Exports (x -m), 1981:1-87:2

.15

.10

.05

Q)
<::>"
e o
o
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81:1 82: 83:1 84:1 85:1 86:1 87·

Note: --- fiscal palicy; fiscal policy ond fareign incorne growth

Figure 2. Effect of Policy Changes on Interest Rate (i) and Real Exchange Rate (e), 1981:1-87:2

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32 Joachim Zietz and Donald K. Pemberton

somewhat different pattem. It is little affected through 1983. DuriQ.g the following years, e would
have risen slightly in the absence of a surge in the budget deficit.
The predicted interest and exchange rate changes suggest an interesting conclusion with re-
spect to the transmission process of the budget deficit of the eighties. The budget deficit was
transmitted to the trade balance primarily through the impact on imports of rising domestic ab-
sorption and income rather than of rising interest and real exchange rates. This result is consistent
with the findings of other researchers. For example, using formal causality tests, Darrat [6, 885]
concludes that "even when the traditional path through exchange rates is excluded, budget defi-
cits ... still exert significant and independent causal effects on the trade deficit." Feldstein (9]
identifies one link between budget deficits and domestic demand and hence imports to operate
via increased private consumption. The apparent fact that the federal budget policy of the early
1980s is linked to the trade deficit mainly via domestic absorption rather than via real exchange
rates has also clear implications for the conduct of future economic policy. lt means that there is
little reason to believe that the trade deficit can be reduced significantly without a reduction in
private and/or govemment consumption. As neither of these options is generally considered easy
to achieve on political economy grounds, policy makers have an obvious interest in less painful
altematives. One of these is discussed next.
Recent work by Batten and Belongia [2], Krugman and Baldwin [18] as well as the simula-
tion results obtained from large macroeconomic models for the U. S. imply that increased growth
by the main trading partners of the U.S. could provide a viable way to reduce the U.S. trade
deficit [5]. The following simulation experiment is intended to check on this. Starting in 1981:1,
foreign in come (y*) was raised such that its average growth rate increased from its historicallevel
of 2.06 per annum between 1979 and 1987 to 2.36, the comparable U. S. rate of income growth. 19
Figures 1 and 2 superimpose the effect of this accelerated foreign income growth on the fiscal
policy (budget policy) experiment discussed earlier.
According to Figure 1, stronger foreign income growth, at a leve! equal to that experienced
in the U.S., would have reduced the U.S. trade deficit by about $18 billion by 1986. The combi-
nation of a lower budget deficit and accelerated foreign income growth could have cut the trade
deficit by more than $55 billion in early 1986. In contrast to a cut in the U.S. budget deficit,
stronger foreign income growth would have raised both U. S. interest rates (Figure 2) and income.
Real gross national product would have been O. 7 percent larger by the year 1987. Given the nega-
tive association between domestic income and net exports, any rise in domestic income, however,
weakens the trade balance. In this sense, the role higher foreign income can play in lowering the
U.S. trade deficit is limited, especially when one adds the fact that foreign income growth also
implies a rising real exchange rate (Figure 2). 20
The simulation results lend themselves to one final interesting observation. Although the
model simulations assumed a perceptible increase in foreign income and a very substantial cut in
the structural budget deficit, they did not manage to cut the trade deficit even in half by 1987.
lt appears then, that the trade deficit cannot be blamed only on the budget deficit and sluggish
foreign income growth. Other factors are likely to be at work as well. Insofar as this is true,
microeconomic explanations for the persistence of the trade deficit are called for.

19. The foreign income series that is used for simulation purposes (v;) is constructed as y,; = y* · (1 +
.00076015)'d, with the time trend td being equal to zcro in 1981 :l. The cyclical pattem of y* is fully maintained through
this transformation.
20. Compare in this respect Darrat's [6] conclusion that foreign income is not among the main causal variables for
the U. S. trade deficit.

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 U.S. BUDGET AND TRADE DEFICITS 33

V. Conclusions

In this paper we have analyzed the inftuence of both federal budget deficits and sluggish foreign
income growth on the U.S. trade deficit of the early 1980s. In contrast to numerous previous
studies that have relied on semi-reduced form models, the analysis has been conducted in a simul-
taneous equation framework. There are three main results. First, it appears that the persistence
of the U. S. trade deficit of the 1980s cannot be fully explained by macroeconomic fundamen-
tals alone, at least not as they relate to the federal budget deficit and sluggish foreign income
growth. There seems to be a role also for microeconomic explanations of the trade deficit. Sec-
ond, the budget deficit affects the trade deficit mainly through its impact on domestic absorption
and income rather than through higher interest and exchange rates. Third, sluggish foreign income
growth has contributed to the U. S. trade deficit of the eighties. But its share has most likely not
been dominant.

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