THE RELATIONSHIP OF THE CURRENT ACCOUNT BALANCE

AND THE BUDGET BALANCE

by L.E. Winner*

Abstract

This paper demonstrates that the traditional theory, that the current account balance and the budget
balance are positively related, does not uphold when applied to Australian data. On the other hand,
Australian data seems to indicate that Ricardian Equivalence Theorem better explains the move
ments in the economy.

When Australia ismentioned many images come The second section analyzes theAustralian econ
tomind including Crocodile Dundee, the last fron omy's current account. Two approaches
are used:

tier, and the lucky country. However, Australia is
not as "lucky" as its image. Australia has one of the
world's highest living standards in the world but a
foreign debt comparable to that incurred by third
world nations. An ongoing sign of the magnitude
of the foreign debt accumulation is the current
account deficit. The current account deficit has
risen to A$15 billion dollars and makes up four
percent of the gross domestic product(GDP). (7)
In the early eighties, Australia was running a
large budget deficit. The government took active
measures to turn this around and is now operating
with a large budget surplus. While achieving a sur
plus, the government hoped Australia's foreign debt
accumulation, represented by the current account
deficit, would become smaller. However, the prob
lems in the economy are deeper than just turning
the budget deficit around. The desired effect on
the current account deficit did not occur; in fact
the current account deficit became larger.
This paper includes a discussion of two oppos
ing theories underlying the relationship of the
budget deficit to the current account deficit. The
first is the traditional theory,which is based on the
IS-LM model, which states that as the government
budget balance increases the current account
should also increase. In contrast, the Ricardian
Equivalence theorem suggests that if the govern
ment budget balance ispositive, therewill no longer
be expectations of an increase in taxes and in turn,
households will lower their private savings. The
Savings-Investment Identity shows that the current
account does not necessarily follow the positive
direction of the government budget balance.
The first,using regression, shows that the govern
ment budget balance did not have a statistically
significant impact on the current account balance.
It indicates that the theory behind the traditional
model is not supported in the case of Australia.
The second approach analyzes the investment iden
titydata by looking at individual figures for each
year. Both approaches suggest that the Ricardian
Equivalence Theorem provides a better explana
tion of the Australian current account than the
traditional model.
By applying two contrasting theories to the rela
tionship between the current account balance and
the budget balance using Australian data, this
paper clearly shows that the Australian current
account balance and the budget balance were not
directly related.
Economic Theory
The Traditional Model
It is commonly believed that a decrease in the
budget deficit has a positive effect on the current
account deficit. If a country begins to decrease its
budget deficit, that is if taxes increase or govern
ment spending decreases, as shown inFigure 1, the
IS curve would shift back causing GNP and inter
est rates to fall. The drop in interest rates would
cause the currency to depreciate and net exports
to increase. This shift back in the IS curve also
causes the aggregate demand curve to shift back.
Since prices are sticky they will not change in the
short run. In the long run, the LM curve will shift

*PhD student in economics, University of Iowa.

graduate
The is based an thesis to The Colorado College.
paper upon undergraduate presented

78 THE AMERICANECONOMIST
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out to bring the economy back to potential GNP. model.(l) This theory can be explained with refer
This causes interest rates to drop even further. ence to the Savings-Investment Identity.
There will also be movement along the aggregate
- -
demand curve as the economy moves back to equi Sr = I Sp Sg (1)
librium. This increase in net exports causes a cur
rent account deficit to decrease or current account This says that world savings equals investment
surplus to increase. minus private savings minus government savings.
The rest of the world savings is equivalent to the
inverse of the current account. Thus:
Interest
Rates v -
Sm CA = Sp + Sg I (2)

For example, ifgovernment savings increases but

the current account deficit does not improve it is
due to either significantly lower private savings or
much higher investment.
When the government reduces taxes which
increases disposable income, themoney borrowed
plus interestmust be paid back. This type of gov
ernment spending is financed by deficit spending
through bond sales. Traditional theory suggests that
government spending financed by deficit spend
ing rather than by taxes will cause interest rates to
y* Income rise. Ricardo, on the other hand, stated that nei
ther deficit financed spending nor tax financed
Price as spending affects the interest rate, and that only
the level of government spending matters.
Ricardian Equivalence states that ifgovernment
purchases remain constant and taxes are reduced,
individuals will anticipate a tax increase sometime
in the future. Therefore individuals will allocate
the increase in disposable income dollar for dollar
to savings. The interest earned on thismoney will
cover the interest payments the government will
incur. There will be no change in the present value
of real taxes. National savings will remain constant,
because dollar for dollar, the increase in private
^^^^^^ ID savings equals the decrease in government savings.
\^ There will be no change inwealth unless govern
^^_ fl)'
ment spending changes. The current account
y* Income should remain the same if the change in private
SOURCE: Hall, Robert E. and John B. Taylor, Macroeconomics, savings equals the change in government savings.
2nd ed., (New York: W. W. Norton &Co., 1988).
In the traditional model, Figure 2, if taxes
increase and investment and government spend
FIGURE 1. Contractionary Fiscal Policy in the ing remain the same constant demand for loanable
IS-LM Model. funds will fall. This fall in demand will cause the
demand curve the shift back and the equilibrium

Ricardian point of supply and demand for loanable funds

Equivalence
will move fromR0 to R{.
Ricardian Equivalence suggests that the budget Under Ricardian Equivalence, private savings
balance and current account balance are not depend on the size of the deficit. The amount
directly related, as concluded from the traditional borrowed will eventually have to be repaid plus

Vol. 37, No. 2 (Fall 1993) 79

 interest. Private savings are positively related to account equation. In addition to the budget bal
the deficit. The public sets aside money to pay for ance, real interest rates, real exchange rates, real
the future increase in taxes. Private savings will output(GDP), themonetary base, inflation and for
decrease dollar fordollar with the fall in the deficit. eign real income should be included. (4, p. 882)
Note that the interest rate, the exchange rate, and
the budget deficit are all included in this model
R
because, even though theory suggests that the
budget deficit affects the interest rate which in
turn affects the exchange rate and thus the cur
rent account balance, there is an independent effect
by each one. These independent effects are sum
marized below.

R I

V^)-To
*i-^\^
-
Go Ti
forLoanable
I_V
Funds
Supply and Demand o
Ri--V.--V^
SOURCE Froven. Richard T.. Macroeconomic Theories and
Policies. 3rd ed, (New York: MacMillian Pub. Co., 1990), p. 546.

FIGURE 2. Interest Rates in theTraditional Model.

-
Go Ti
In Figure 3, Ricardian Equivalence states that I_V
Supply and Demand forLoanable Funds
as demand shiftsback, the supply of loanable funds
will also shift backwards to the point where the SOURCE: Froyen, Richard T., Macroeconomic Theories and
Policies. 3rd ed., (New York: MacMiilian Pub. Co., 1990), p. 547.
interest rate has remained unchanged. The shifts
in the supply and demand for loanable funds there
fore counterbalance each other. This shows that FIGURE 3. Interest Rates Under the Ricardian
interest rates hold constant if there is a tax increase Equivalence.
to reduce the deficit or a tax cut which increases
the deficit. This model supports the notion that
Interest Rate
only the level of government spending affects the
interest rate. The nominal interest rate is represented by the
10-week Treasury Bill figures.The real interest rate
was found by:
Analysis of theCurrent Account Balance
Real Interest Rate = Nominal Interest
Regression Analysis ?
Rate Change inConsumer Prices (3)
Regression analysis, on the relationship of the
current account balance to the budget balance,
Exchange Rate (5, p. 85; 2, p. 13)
indicates that the budget balance has had an insig
nificant effect on the current account inAustral The nominal exchange rate is represented by
ia's case. A ninety-five percent level of significance the Multilateral Exchange Rate Model(MERM).
is used. The MERM is a nominal effective exchange rate
A simplified version presented by Ali F. Darat which "represents the model's estimate of the
is used in the analysis. He suggests that there are medium term effect on a country's trade balance
many factors which are important in the current of a 1 percent change in domestic currency price

80 THE AMERICANECONOMIST
 -
of each of the other currencies." (7) The MERM is CA = -.0153 + .235 BUD .00466
- -
an indexed rate with a base year of 1985. The real INFLATION .0052R .000094
exchange rate is found by: X-RATE + .0000003
GDP +
.00125
W GDP (6)
Real Exchange Rate = Nomina Exchange
Rate (WorldCPI/AustralianCPI) (4) Referring to Table 1, in this regression none of the
coefficient estimates are statistically significant at
95 percent, but the closest two once again are the
Gross National Product
real interest rate coefficient, with a t-statistic of
GDP is represented by GDP with a base year of 1.84, and the inflation coefficient, with a t-statistic
1985. of 1.4. The t-statistic for the budget balance coef
ficient is once again low at 1.13.
Monetary Base (3, p. 146)

In the present study, the monetary base is

TABLE 1
represented by money, Ml.
Dependent Variable: Current Account Balance
as a Share of GDP

Inflation (3; 2, p. 15) Coefficient Estimates

The inflation rate is represented by the change Independent Variable (T-Statistics inParentheses)
in consumer prices. _1_2
Constant .0637 -.0153

(.69) (.24)
Foreign Real Income
InterestRate .00638 -.0052
Foreign real income is represented by world GDP (2.15) (1.84)
at constant prices. The world GDP figure is shown -
as a percent change over the previous year. Exchange Rate .000119 .000094
(.37) (.29)
Although theories predict certain effects between
the budget balance and the current account bal Budget .319
.235
ance, they do not tell how tomeasure them. Thus (1.47) (1.13)
two versions for the current account balance,
GDP.0000003 .0000003
budget balance, and money supply are used. The (.52) (.72)
first, is found by dividing the nominal rates by GDP
to give its share. The second, is found by dividing Money .377

the nominal rate by the CPI, which has been (1.16)

divided by 100, to give the real magnitude. Inflation .00623 -.00466
The first regression equation estimated is: (1.75) (1.40
World GDP .00129 .00125
CA = .0637 +.319 BUD -.00623
- - (.35) (.33)
INFLATION .00638 R .000119
X-RATE + .0000003GDP + .00129 61.4%
R-SQ 57.1%
W GDP - .377MONEY (5) R-SQ (Adj) 38.9% 37.3%

Referring to Table 1, the real interest rate coeffi

cient is the only one which is statistically signifi In the second method, when real figures are used
cant with a t-statistic of 2.15 and the inflation for the current account balance, the budget bal
coefficient is very close with a t-statistic of 1.75. ance, and money, the regression equation esti
The t-statistic on the budget balance coefficient is mated is:
considerably lower at 1.47. However, there is cor
relation between GDP and money at 91.5 percent, CA = 4322 + .057BUD + .00000056
so another regression was run without themoney MONEY = .0098GDP- 114 W GDP
variable. The - - -
regression equation estimated for 1001 R 29.9 X-RATE 939
this is: INFLATION (7)

Vol. 37, No. 2 (Fall 1993) 81

Referring to Table 2, once again the interest rate are other factors besides government savings which
coefficient was statistically significant with a influence the current account.
t-statistic of 2.11 and the inflation coefficient was
- ~ -
almost significantwith t-statisticof 1.69.The budget CA = Sp I (G T) (8)
balance coefficient was very insignificant with a
t-statistic of .23. Where the current account represents the inverse
of rest of the world savings, Sp stands for private
?
TABLE 2 savings, and (G T) stands forgovernment spend
Dependent Variable: Current Account Balance in 1985 $ ing minus taxes and represents government sav
Coefficient Estimates ings. The combination of gross fixed capital plus
an increase or decrease in inventory stock will be
Independent Variable (T-Statistics inParentheses)
1 used to represent investment.
In Table 3, the data for investment, private sav
Constant 4322
ings, government savings, and the current account
(.3D
have been divided by GDP. This ratio measures
Interest Rate -1001 the relative importance of these factors, i.e. there
(2.11) could be an increase in the dollar amounts but a
Rate -29.9
decrease in the percentage of GDP.
Exchange
(.59) Through the identity, it is obvious, for example,
that if investment and government spending are
Budget .057 held constant an increase in private savings will
(.23)
cause an increase in the current account. The oppo
GDP .0098 site is truewith the government budget deficit and
(.11) investment; they should decrease if there is a rise
in the current account. It is therefore true that if
Money .00000056
(.03) there is a decrease in the current account, private
savings will decrease or the government budget
Inflation -939
deficit and/or investment will increase.
(1.69)
Since the concentration of this paper in on the
World GDP .114 years from 1984-89, when the budget deficit moved
(.19) in a positive direction towards a surplus, the anal

R-SQ 76.8% ysis will concentrate on these years.

R-SQ (Adj) 63.3%
In the equations very few of the t-ratios are of
statistical significance. One reason may be there are
six to seven variables in each equation and only
twenty years of data. The high correlation between
GDP and money could also be caused by the small
data set.However, the t-ratioson the budget balance
coefficients in all the equations show that the budget
balance is consistently insignificant. This indicates
that a relationship between the current account
and budget balances still seems quite doubtful.
Investment-Savings Identity Approach
The investment identitycan now be used to show
how private savings and investment may have
affected the current account. (9, p. 293-94) Manip
ulating the investment identity shows that there
Referring to Table 3, from 1984 to 1985, the
budget deficit began to drop as a percentage of
GDP by almost one percentage point. However,
the current account balance as a percentage of
GDP only decrease by .3 percentage points. There
was a small increase in private savings which should
have helped the current account but there was an
increase of two percentage points in investment,
which counteracted the budget deficit decrease
and increase in private savings.
From 1985 to 1986, the budget deficit continued
to decrease from a negative three percent of GDP
to 2.35 percent, while the current account deficit
remained approximately the same. Investment also
decreased by approximately two percent, returning
to its 1984 level. A decrease in investment should
have had a positive effect on the current account.
Therefore, private savings must have dropped
significantly, which it did by almost 2.7 percent
age points from 25.39 to 22.74 percent.

82 THEAMERICANECONOMIST
 TABLE 3
Investment-Savings IdentityAs A Share Of GDP

YEAR_CA/GDP_BUD/GDP_I/GDP_Sp/GDP
-0.0424678
1984 -0.0396432 0.240486
0.243310
-0.0394422
1985 -0.0299690 0.253918
0.263391
-0.0393768
1986 -0.0235937 0.227438
0.243221
-0.0308273
1987 -0.0119065 0.223165
0.242086
1988-0.0345824 0.0071483 0.253731 0.212001

1989_-0.0439009_0.0207533_0.268776_0.204122

From 1986 to 1987, the budget deficit shrank but In the final year from 1988 to 1989, the budget
at a slower rate of only .65 percentage points. The balance continued to run a surplus increasing by
current account deficit did follow this year in a almost 1.5 percentage points but the current
positive movement, decreasing .85 percent. The account balance fell by almost one percentage
effects of changes in private savings and invest point. Once again investment rose by 1.5 percent
ment cancelled each other out. age points and private savings fell by almost one
From 1987 to 1988, the budget deficit moved percentage point, causing the negative effect on
drastically, increasing from negative 1.19 percent the current account.

of GDP to a positive .7percentage points, a change
of almost two percentage points. The current
account did not follow thismovement and fell by
almost .5 percentage points. Investment rose by
almost one percentage point which by itselfwould
have had a negative effect on the current account.
The change in investment was compounded by a
fall in private savings. Private savings fell by a lit
tlemore than one percentage point also having a
negative effect on the current account.
Even though private savings did not change dol
lar for dollar in relation to the positive movement
in the budget balance, they did move in the oppo
site direction, further supporting the Ricardian
Equivalence Theorem.
Talking about one or two percentage points may
not sound like a large amount but when the actual
figures, shown inTable 4, are examined the impact
can be better understood.

TABLE 4
Investment-Savings Identity inReal Values

I
YEAR_Real
CA_Real Bud_Real Sp_Real
1983
-6511.1 -5022.22 42733.3
44222.2
1984
-9215.1 -8602.15 52182.8
52795.7
1985
-8910.0 -6770.00 57360.0
59500.0
1986
-8926.6 -5348.62 51559.6
55137.6
1987
-7262.9 -2805.08 52576.3
57033.9
1988
-8642.9 1786.51 52983.3
63412.7

1989_-11527.2_5449.26_53597.1_70573.5

Conclusion Savings-Investment Identity shows that both sav

Regression analysis demonstrates that the budget
deficit has had no significant impact on the cur
rent account. This finding fails to support the tra
ditional theory, indicating support for the Ricardian
Equivalence Theorem in the case of Australia. The
ings and investment have had a great impact on
the current account and have counteracted the pos
itivemovements of the budget balance in recent
years. This clearly demonstrates that in the case
of Australia the Ricardian Equivalence Theorem
supports themovements in the economy.

Vol. 37, No. 2 (Fall 1993) 83

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84 THE AMERICANECONOMIST