Q. Discuss the effects of government deficits on the current account.

Answer: A difficult and hard issue that during the Reagan administration the creation of twin deficits whereby government deficits increased, slashing taxes which was accompanied with increased current account deficits.

Using an identity CA = Private Saving - I - (G - T) one is able to see that if private savings and I are constants an increase in the deficit specifically an increase in (G - T) unavoidably increases the CA deficits by the same magnitude. Conversely government budget deficit may change both private savings and investment therefore avoiding a creation of the twin deficits. An illustration is the European countries reducing their budget deficits just previous to the introduction of the euro in January 1999. Now in the "twin deficits theory" one would have expected the EU's current account surplus to increase. This has by no means happened. The major reason was sharp reduction in private saving rates.

A Ricardian equivalence which dispute that when the government cut raises and taxes its deficit consumers anticipate that they will face higher taxes later to pay for the resulting government debt. In anticipation they increase their own private saving to offset the fall in government saving. Additionally one should mention wealth effect in anticipation of one Europe assets prices increased lowering private saving rates.