out of balance: the effects of current account and fiscal balances on growth and inflation in the...

7/31/2019 Out of balance: The effects of current account and fiscal balances on growth and inflation in the Eurozone

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Out of balanceThe effects of current account and fiscal balances ongrowth and inflation in the Eurozone

Jennifer EvansStudent number: 3409740Applied Economics Research CourseSupervisor: Dr. Kevin NellUtrecht School of EconomicsJune 27, 2011

ABSTRACT

Macroeconomic imbalances between European member states have stirredup an intense political debate since the financial crisis began in late 2007.However, in order to discern the proper policy response, it is important toconsider the source of these imbalances. To study the relationship betweenthe current account balance, the fiscal balance, inflation and growth withineconomies of different sizes in the Eurozone, Granger causality tests areperformed on Germany, the Netherlands, Spain and Portugal. The results

suggest excess inflation in smaller Eurozone economies can be addressed bytighter fiscal policies. Furthermore, they indicate that countercyclicalpolicies could be a better remedy for fiscal deficits than the procyclicalrecommendations proposed in recent Stability and Growth Pact reforms.


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Table of Contents

1. Introduction ...............................................................................32. Literature review........................................................................5

The fiscal balance, the current account and inflation ..................5Current account and fiscal balances in the Eurozone ..................7Inflation in the Eurozone ...........................................................11The crisis................................................................................... 12

3. Empirical framework ............................................................... 13

4. Data and Methodology.............................................................. 15

5. Results...................................................................................... 17(H1) .......................................................................................... 17(H2) .......................................................................................... 18(H3) ..........................................................................................20(H4) ......................................................................................... 21(H5) ..........................................................................................25

6. Conclusion ...............................................................................26

7. References................................................................................28

8. Appendix..................................................................................30Variable definitions ..................................................................30Descriptive statistics .................................................................30

Sensitivity analysis.................................................................... 31Summary of results................................................................... 31


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1. Introduction

Macroeconomic imbalances between European member states have

stirred up an intense political debate since the financial crisis and subsequent

recession began in late 2007. European Union (EU) leaders worry that these

imbalances will harm the credible of the Euro and cause financial turmoil

leading to additional crises (Baldwin, 2010). In 2010, the EU set up the Van

Rompuy Commission to investigate and draft policy measures that would

address the growing divergence. Less than a year later, amid the continuing

European Sovereign Debt Crisis that began in 2009, the president of the

European Central Bank (ECB) proposed that the Eurozone deepen its fiscal

coordination by creating a European ministry of finance (Hewitt, 2011).

However, when investigating solutions for these divergences, it is

important to consider their source, and how these variables interact with one

another. Eurozone members have different types of economies and levels of

per capita GDP, which may be reflected in their current account and fiscal

balances as well as inflation rates. For example, catch-up growth caused when

poorer Southern countries joined the Eurozone may be the reason for their

current account deficits as these countries build their capital stock via

imports. If Eurozone policies inadvertently slow the growth of the catch-up

countries, it also makes it harder for these governments to pay back the debt

they accumulated in order to grow.

On the other hand, if the smaller Eurozone economies are racking up

fiscal and trade deficits only to fuel higher consumption in light of low

borrowing costs, it is difficult to justify such behavior. The market may react

negatively to high fiscal balances, leading to a situation like the Sovereign

Debt Crisis, in which countries are unable to borrow on the market, or only

able to borrow at unsustainable interest rates, to fund their spending.

Furthermore, increasing fiscal deficits may be associated with increasing

inflation, which drives up a countrys real exchange rate and decreases the

competitiveness of its exports.

This thesis will investigate the effect of current account and fiscalbalances on growth and inflation through Granger causality tests. Throughout


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the paper, the subquestions listed in Box 1 below will be answered. Two sets of

Granger causality models will be run on two large Eurozone economies,

Germany and the Netherlands, and two smaller Eurozone economies,

Portugal and Spain. The variables under investigation were chosen because

they reflect the main economic restrictions to Eurozone countries via the

Stability and Growth Pact (SGP) framework1 and the common monetary

policy. These variables also allow a potential cause of the twin deficit

relationship to be tested.

In the next section, the literature on the fiscal and current account

balances, inflation and growth will be reviewed. Through the literature review

the hypotheses will be discussed, and the first Subquestion will be answered.Thereafter a short empirical framework will follow. Methodology and data will

be then be treated. In section 4, the empirical results will be addressed. The

paper will close with a general conclusion.

1The Stability and Growth Pact is a framework for coordinating fiscal policy between the EUMember States. The Maastricht criteria, also mentioned in this paper, refer to the both thefiscal and monetary rules laid out in the Maastricht Treaty (European Commission).

Box 1. Main question and subquestionsWhat is the effect of current account and fiscal balances on growth and inflation in theEurozone?

1.

What are some reasons for large macroeconomic imbalances between Eurozonecountries?

2. Does the fiscal deficit lead to a current account deficit in smaller Eurozone economies?Does this hold for larger economies?

3. Do fiscal and current account deficits predict future growth?4. Is there a relationship between inflation and growth, and is it more significant in smaller

Eurozone economies than larger economies?

5. Is there a relationship between inflation and the budget deficit, and is it more significantin smaller Eurozone economies than larger economies?


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2. Literature review

The fiscal balance, the current account and inflation

The basic background information about the current account, the fiscal

balance and inflation will be covered here. Definitions and identities will be

used to put the various relationships into context before addressing specific

theory about these macroeconomic indicators in the Eurozone over the past

decade. Keep in mind that the identities given in this section cannot be used to

make economic forecasts or explain economic occurrences without additional

economic theory and theory-based models. Rather, they are used here instead

to flesh out the basic relationships addressed in this paper.

The fiscal balance

Government spending includes spending by federal, state or local

governments, and includes both consumption and investment spending such

as federal military spending, government support of cancer research and

funds spent on highway repair and education (Krugman & Obstfeld, 2009).

Government spending as a percentage of gross domestic product (GDP) gives

insight into the magnitude of fiscal deficits or fiscal surpluses, and allows one

to compare fiscal positions across countries. In the Eurozone, countries may

not have a fiscal deficit above 3 percent of GDP except in certain

circumstances (Europa). Reforms to the SGP that were adopted in 2010 have a

stronger focus on medium-term deficit and debt levels, and included a

provision that all countries exceeding the debt limit will be required to reduce

it every year, at a rate of one twentieth of the excess debt (Manasse, 2010).

Government spending makes up an important part of national income,

and affects the composition of aggregate demand. In the income identity for

an open economy, the sum of expenditures always equals income and is given

by Y=C+I+G+(X-M). Y is national income, C is consumption, I is investment,

G is government spending, and (X-M) is net exports (Krugman & Obstfeld,

2009). The government deficit is defined as (G-T), and measures to what

extent the government is borrowing to finance its expenditures. (2009).


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While Y does not change if G increases, the composition of aggregate demand

changes, which will be discussed further below (Gartner, 2009).

The current account

To extend this discussion to current account balances, the current

account can be represented by net exports, or CA=(X-M). Together with the

financial account and the capital account, the current account is part of the

international balance of payments. The current account records the net

exports of goods and services, while the financial account measures the

difference between sales of assets to foreigners and purchases of assets abroad

(where buying international assets is recording as a - and selling domestic

assets internationally a + in the financial account) (Krugman & Obstfeld,

2009). The current account and financial account mirror one another: a

deficit in the current account must be financed with a surplus in the financial

account. The capital account measures transfers of wealth between countries,

and for the most partresult[s] from nonmarket activities orpossibly

intangible assets (such as copyrights and trademarks) (2009). The financial

and capital accounts will not be discussed further in this paper.

The national income identity can also be rearranged so that the current

account represents the difference between national income and domestic

residents spending: Y-(C+I+G) = CA (2009). Since savings is Y-C-G, it can

also be represented by S=I+CA. The current account, in turn, can be

represented as savings minus investment, S-I. (2009)

The national income identity can also be written by indentifying all the

leakages (public and private savings, or S=Y-C-G, taxes, T, imports) andinjections (government expenditure, investment, exports) in the economy as

(S-I)+(T-G)+(M-X)=0 (Gartner, 2009),which is helpful in identifying changes

in the composition of aggregate demand. According to Krugman & Obstfeld

(2009), an increase in G will not affect S or I, but instead induce a rise in (M-

X), implying a decrease in net exports. While the term twin deficits refers to

countries that run both fiscal and current account deficits, it is important to

note again that no explanation for the cause of twin deficits can be gleaned

from simple identities.


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Inflation

Inflation is simply defined as the rate at which prices increase (Gartner,

2009). Inflation can be driven by increases in demand for things like food and

labor. Additional causes for inflation can include

domestic developments such as wage increases out of line with

productivity and employment considerations, inappropriate

fiscal policies, unsustainable expansions of profit margins or

untenable demand developments caused by, for instance,

excessive increases in house prices or financial asset price

bubble (European Central Bank(1), 2003).

Typically, a countrys national central bank is charged with maintaining

price stability within a country through the use of monetary policy. Many

central banks achieve this via inflation targeting goals. Loose monetary policy

is associated with increasing inflation (an increase in the rate at which prices

rise) while restrictive policy is associated with a reduction of the rate at which

prices rise (2009). In the Eurozone, countries are governed by one monetary

policy carried out by the European Central Bank (European Central Bank(2)).

According to its website, the ECB aims at inflation rates of below, but

close to, 2% over the medium term. The Maastricht criteria for Eurozone

countries stipulates that a countrys inflation rate should be no more than 1.5

percentage points above the rate for the three EU countries with the lowest

inflation over the previous year (Europa).

Current account and fiscal balances in the Eurozone

In their investigation into the divergent current account imbalances in

the Eurozone, Blanchard and Giavazzi (2002) describe them as a natural

consequence of European integration. It is what theory suggests can and

should happen when countries become more closely linked in goods and

financial markets: poor countries with higher expected rates of return and

better growth prospects should see an increase in investment and a decrease

in savings (2002). Both a decrease in savings and an increase in investment


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deteriorate the current account. See Table 1 for a comparison of real GDP per

capita in the four countries under investigation in this paper.

Table 1, GDP per capita in US $, constant prices, constant PPP

Germany Netherlands Portugal Spain

2000 25,949 29,406 17,749 21,320

2001 26,222 29,746 17,980 21,850

2002 26,177 29,577 17,976 22,119

2003 26,108 29,537 17,684 22,429

2004 26,430 30,099 17,856 22,789

2005 26,641 30,638 17,910 23,228

2006 27,571 31,631 18,108 23,794

2007 28,339 32,797 18,498 24,202

2008 28,669 33,288 18,472 24,025

2009 27,398 31,817 17,994 22,961

2010 28,434 32,215 18,228 22,857

Data from OECD

European integration also had an effect on lending and borrowing

behavior. Blanchard and Giavazzi (2002) explain that the Eurozones financial

and monetary integration lowered perceived risks for investors, and the

borrowing costs for both consumption and investment. Eurozone regulations

also improved the quality of available information (2002). These

developments encouraged investors to lend to Eurozone governments. In

addition to the perceived drop in risk and lower borrowing costs, the Eurozone

offered access to credit which may have not been previously available to

countries which recently joined (Gruber and Kamin, 2007). Between the four

countries under investigation in this paper, the theory predicts that theNetherlands and Germany would run current account surpluses, and Portugal

and Spain would run current account deficits.

Twin deficitsAccording to the story above, increased borrowing opportunities

stemming from European integration may have caused fiscal deficits that in

turn led to current account deficits also observed in this period. There are

several papers dedicated to twin deficits relationship. Khalid and Guan


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(1998) investigated the connection on a sample of developing and developed

countries between the 1950s and early 1990s. They argue that in a Keynesian

framework, budget deficits would increase demand and expand imports,

deteriorating the current account (1998). The Keynesian theory is well

explained in a 1993 article by Seater:

On the one hand, an increase in debt stimulated theeconomy in the short run by making households feel

wealthier. On the other hand, public debt competed withprivate debt for available funds, thus driving up interestrates and changing the composition of output, inparticular crowding out private investment. (1993)

Similarly, Freund (2005) wrote in her paper on the costs of current account

reversals that a budget deficit could worsen the international balance because

of the impact of higher government spending on aggregate demand (2005).

Table 2 below shows that Portugal and Spain (except for 2005-2007) have

consistently had twin deficits since 2000. The Netherlands and Germany,

however, have run fiscal deficits without any effect on the trade deficit. In my

analysis, I expect the fiscal deficit to Granger cause trade deficits in Portugal

and Spain, but to find no link between the two deficits in the Netherlands and

Germany.

Table 2, Current account and fiscal balances as a percentage of GDP

Germany Netherlands Portugal Spain

CA Fiscal CA Fiscal CA Fiscal CA Fiscal

2000 -1.8 1.3 1.9 2.0 -10.4 -2.9 -4.0 -1.0

2001 0.0 -2.8 2.4 -0.2 -10.4 -4.3 -4.0 -0.6

2002 2.0 -3.7 2.5 -2.1 -8.3 -2.9 -3.3 -0.5

2003 1.9 -4.0 5.5 -3.1 -6.5 -3.0 -3.5 -0.2

2004 4.6 -3.8 7.6 -1.7 -8.3 -3.4 -5.2 -0.3

2005 5.0 -3.3 7.4 -0.3 -10.4 -5.9 -7.4 1.0

2006 6.2 -1.6 9.3 0.5 -10.7 -4.1 -9.0 2.0

2007 7.5 0.3 6.7 0.2 -10.1 -3.1 -10.0 1.9

2008 6.2 0.1 4.4 0.6 -12.6 -3.5 -9.6 -4.2

2009 5.6 -3.0 4.9 -5.5 -10.2 -10.1 -5.1 -11.1

2010 5.6 -3.3 7.6 -5.4 -9.7 -9.1 -4.5 -9.2

Data from OECD and Eurostat


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Despite the theoretical evidence, empirical confirmation that the fiscal

deficit causes the current account deficit in both developing and developed

countries has been less than conclusive (Khalid and Guan, 1998). There may

be, for example, a third variable that affects both the current and the fiscal

balance in the same way (Vamvoukas, 1999). As Blanchard and Giavazzi

(2002) imply, increased borrowing and current account deficits are

consequences of catch-up growth among smaller European economies.

Causal relationship between fiscal deficits and current account deficits among

smaller economies in the Eurozone may be an outcome of, or lead to,

economic growth.

Freund (2005) also suggests that strong income growth leads to aworsening current account deficit, and as growth slows the current account

imbalance shrinks. In this case, causality may run from growth to the fiscal

balance (strong growth or growth prospects making investors more willing to

lend) to the current account balance. It is also possible the causality runs from

growth directly to the trade balance because the textbook Keynesian model

predicts a worsening of the trade balance both under fixed exchange rates and

under flexible exchange rates when trade balance is made a function of

income (Beetsma, Giuliodori and Klaassen, 2007). In my analysis, I expect

growth to predict further deterioration of the fiscal and trade balances because

higher incomes would increase demand, and higher growth prospects may

make investors more willing to lend to a country. Causality is expected to run

both ways, with fiscal and trade deficits also leading to growth.

The most popular argument against the idea that fiscal deficits cause

current account deficits is Ricardian Equivalence, which states that deficitspending by governments will not affect economic activity (Seater, 1993).

With Ricardian equivalence, a public budget deficit immediately stimulates

private savings to pay for future taxes, which implies an improvement in the

current account balance (Reisen, 1998).

However, look at recent Eurozone data shows that the channel

through which [the current account deficits] occurred appears to be primarily

a decrease in savingstypically private savingsrather than increased


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investment (Blanchard and Giavazzi, 2002). And Jaumotte and

Sodsriwiboon note that current account deficits in the Euro zone during the

2000s were heavily financed with debt instead of FDI even though the

creation of the EMU was marked [at first] by a substantial improvement in

macroeconomic policies, including fiscal balances (2010). According to the

authors, Spain, Greece and to a lesser extent Italy were large importers of

bond-related inflows, while Portugaltook in large foreign loans at the

beginning of the 21st century (2010). Jaumotte and Sodsriwiboon have

suggested increased government savings fiscal consolidation as a means to

reign in deteriorating current accounts (2010).

Inflation in the Eurozone

Even though Eurozone countries are governed by one monetary policy,

they do not all have the same level of inflation due to structural difference and

persistent pre-Eurozone inflation (Lane, 2006). In such a situation, real

interest rates should differ: higher-inflation countries would have lower real

interest rates, and the real interest rates in lower-inflation countries would be

higher. According to Blanchard and Giavazzi (2002), monetary policy kept

interest rates low in the early 2000s, which reduced real interest rates and

increased demand in persistent-inflation countries like Spain, exacerbating

the problem. At the same time, the policy kept investment demand and

inflation low in Germany (2002). See Table 3 for an overview of inflation in

the Eurozone countries of interest since 2001.

Table 3, Yearly inflation in select Eurozone countries

2001 2002 2003 2004 2005 2006 2007 2008 2009

Germany 1.94 1.48 1.04 1.65 1.52 1.60 2.26 2.60 0.38

Netherlands 4.16 3.29 2.11 1.24 1.67 1.17 1.61 2.49 1.19

Portugal 4.35 3.56 3.27 2.36 2.29 3.10 2.45 2.57 -0.83

Spain 3.59 3.07 3.04 3.04 3.37 3.52 2.79 4.08 -0.29

Data from OECD


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Balassa-Samuelson Effect

Smaller, post-integration economies may also experience higher

inflation due to the Balassa-Samuelson Effect. According to Rabanal (2006) in

a la Caixa publication, the Balassa-Samuelson effect is typically used toexplain inflation differentials for those countries experiencing a catching-up

process. He explains the effect as follows:

Suppose that the sectors of an economy that are open tointernational trade (the tradable sectors) experiencehigh productivity growth. This can happen, as in the caseof the EMU, when a group of countries increase economicintegration, barriers to trade fall, and hence it is easier toimport more productive technologies from the more

advanced countries. The higher productivity in thetradable sector increases the marginal product of labor inthat sector, and therefore labor demand. This puts upwardpressure on wages, which increase for the whole economy.Since prices are set as a markup over production costs,inflation increases in the sectors of the economy not opento international trade (the nontradable sector), that donot benefit from productivity improvements but facehigher wages. (2006)

However, Rabanal notes that the economic growth Spain in particular

experienced since 2000 came from the nontradable sector. Declining

productivity in the nontraded sector would imply higher inflation but lower

output in this sector, so the Balassa-Samuelson Effect could not be the only

reason for increasing inflation (2006). The fact that output and prices in the

nontradable sector increased means demand factors must have played an

important role (2006). According to Zemanek, Belke and Schnabl (2009),

second-round inflation effects can be induced from wage increases in the

nontradable sector as trade unions in the tradable sector claim inflationcompensation in the wage bargaining process. I expect growth and the fiscal

balance to Granger cause inflation in Portugal and Spain. However, only

growth will Granger cause inflation in Germany and the Netherlands.

The crisis

The financial crisis and subsequent recession of the late 2000s began

in the last quarter of 2007 and lasted until the first quarter of 2009, according

to the National Bureau Economic Research (NBER, 2010). Because of the


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large effects the crisis had for the global economy, it will be included as a

dummy variable in the Granger regression equations. I expect that the

financial crisis will have a negative and significant relationship with growth on

all countries under investigation. I also expect the crisis to have a negative and

significant effect on the fiscal balance, the trade balance and inflation. For a

review of all the hypotheses mentioned, please see Box 2.

Box 2. Review of hypotheses

1. Fiscal deficits Granger cause trade deficits in Portugal and Spain. There willbe no causal relationship between fiscal and trade balances for theNetherlands and Germany.

2. Fiscal and trade deficits lead to growth in Portugal and Spain, but not inGermany or the Netherlands. The causality between fiscal and trade deficits

and growth for Portugal and Spain will run both ways.3. Growth Granger causes inflation in all countries in the sample.4. The fiscal balance Granger causes inflation in Portugal and Spain, but not in

the Netherlands or Germany.5. The financial crisis of the late 2000s will have a significant negative effect on

growth, the fiscal balance, the trade balance and inflation for all countries inthe sample.


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3. Empirical framework

The endogeneity of economic growth and the chosen variables lends

itself to a vector autoregressive (VAR) model. According to Fregert (2004) a

VAR model is a multi-equation system where all the variables are treated as

endogenous [and] there is thus one equation for each variable as dependent

variable. In addition to testing the given hypotheses, running the Granger

causality specification for each variable in the model also allows to test if

causality runs both ways between a set of variables.

Granger causality tests use VAR-based models to test the predictive

ability of the independent variables on the dependent variable (Studenmund,2006). Causality is determined for each variable by the significance of an F-

test that includes the beta coefficients on all lags. Piersanti (2000) ran

Granger causality tests for a number of OECD countries for data between

1970-1997 to investigate if current account deficits are linked to expected

budget deficits. Vamvoukas (1999) and Khalid and Guan (1998) both use

Granger causality tests to investigate the twin deficits phenomenon

(Vamvoukas, 1999). However, Vamvoukas bases his analysis on trivariate

causality tests in order to prevent spurious results that may occur when

important variables are omitted (1999). Specifically, he runs two separate

models in which either real output or inflationconsiderable determinants of

government and trade deficitsare added as a third variable (1999). While

Vamvoukas uses a Vector Error Correction model and cointegration analysis,

the model used here is an unrestricted VAR as in Aksoy and Piskorski (2006).


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4. Data and Methodology

To study the relationship between the trade balance, the fiscal balance,

inflation and growth within economies of different sizes in the Eurozone,

Granger causality tests will be performed on Germany, the Netherlands, Spain

and Portugal. Seasonally adjusted, quarterly data from Eurostat and the

OECD during the period 1999-4 and 2010-4 is used in the analysis. The trade

balance will be a proxy for the current account balance. The analysis will be

comprised of two models, with three versions of each model used to test the

hypotheses in Box 2, for a total of six equations. The two main models are:

Equation 1.1: tb /gdpt = "0 + "1tb /gdpt#k + "2 y.

t#k+ "3 fis /gdpt#k + "4crisis

Equation 2.1: "t = #0 + #1"t$k + #2 y.

t$k+ #

3fis /gdpt$k + #4crisis,

where y.

is real economic growth, also referred to as growth, fis/gdp is the

fiscal balance, tb/gdp is the trade balance, " , or inf, is the inflation rate and

crisis is a dummy variable that takes a value of 1 in the fourth quarter of 2007

through the first quarter of 2009, and zero otherwise. The subscript trefers to

the present time of each respective quarter, t, and k refers to the lag length

(k=-1, -2, -n). The variable definitions and appropriate lag lengths per

model are further explained in the Appendix.

Equation 1.1 will test Hypothesis 1, found in Box 2, and analyzes if

causality runs from the fiscal balance to the trade balance. This hypothesis is

linked to Subquestion 2. Equation 1.2, listed below, tests the causality from

the fiscal balance and the trade balance to growth.

Equation 1.2: y.

t= "

0+ "

1y.

t#k+ "

2fis /gdpt#k + "3tb /gdpt#k + "4crisis

Equation 1.3 will test if there is reverse causality: if the Granger causality runs

from growth to the fiscal balance as well. Equations 1.2 and 1.3 are key to

answering Subquestion 3 in Box 1.

Equation 1.3:

fis /gdpt = "0 + "1fis /gdpt#k + "2 y.

t#k+ "

3tb /gdpt#k + "4crisis


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Hypothesis 3 and 4, which state that causality goes from growth or the

fiscal balance to inflation, respectively, will be tested with Equation 2.1 below.

These equations will help answer Subquestions 4 and 5 in Box 2. Equation 2.2

and Equation 2.3 are not used to test a specific hypothesis, but will determine

if any reverse causality exists between inflation, growth and the fiscal balance.

Equation 2.1: "t = #0 + #1"t$k + #2 y.

t$k+ #

3fis /gdpt$k + #4crisis

Equation 2.2: y.

t= "

0+ "

1y t#k

.

+ "2fis /gdpt#k + "3$t#k + crisis

Equation 2.3: fis /gdpt = "0 + "1fis /gdpt#k + "2 y.

t#k+ "

3$t#k + crisis

The presence of the dummy variable crisis in each model will be used to

test the effects on the financial crisis as stated in Hypothesis 5.


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5. Results

In this section, the results most pertinent to the original research

question and subquestions will be discussed. Each subquestion2 (in bold) and

hypothesis (in italics) will be considered together. See Boxes 1 and 2 for

summaries of each. For descriptive statistics, a full description of sensitivity

analysis, and a summary of the overall results, please see the Appendix. Tables

5 and 6 on page 24 provide an overview of the p-values of the F-tests

performed on each equation, and will be referred to throughout this section.

(1) Does the fiscal deficit lead to a current account deficit insmaller Eurozone economies? Does this hold for larger economies?

(H1) Fiscal deficits Granger cause trade deficits in Portugal and Spain. Therewill be no causal relationship between fiscal and trade balances for the

Netherlands and Germany.

Fiscal balances d0 not predict trade balances in Portugal or Spain as

tested by Equation 1.1, and reported in Table 5, Rows 9 and 12. Fiscal balances

also do not predict trade balances for Germany (see Row 3). However, in the

Netherlands, fiscal balances do predict trade balances, and the net effect is

negative, such that an improvement in the fiscal balance would lead to a

deterioration of the trade balance. Please see Table 5, Row 6 for the p-values.

Trade balances do not predict fiscal balances for any country in the sample as

investigated with Equation 1.3. The p-values for this specification for each

country are reported in Table 5, Rows 2, 5, 8 and 11.

These results suggest that growing trade and deficit balances (twin

deficits) are the result of another variable affecting them both, possibly

growth, which will be examined next. The results from the Netherlands may

be idiosyncratic to the characteristics of the Dutch economy, and/or the time

period under investigation. The fact that the twin deficits in Portugal and

Spain do not predict each other suggests that simply improving the fiscal

balance would not be enough to improve the current account balance.

2The first Subquestion has been skipped because it was answered in Section 2. Subquestion 2is referred to here as (1).


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(2)Do fiscal and current account deficits predict future growth? Ordoes growth in less developed countries cause fiscal and currentaccount deficits?

(H2) Fiscal and trade deficits lead to growth in Portugal and Spain, but not

in Germany or the Netherlands. The causality between fiscal and tradedeficits and growth for Portugal and Spain will run both ways.

Despite strong theoretical arguments relating to catch up growth and

the current account balance, the significance of the results varies between

Portugal and Spain. Portugal has a lower GDP per capita than Spain (see

Table 1), which implies that results related to catch-up growth would be more

likely to hold for Portugal. However, when Equation 1.2 is run for Portugal,

there is no evidence that fiscal or trade deficits predict growth. See Table 5,

Row 7, for the respective p-values. A look at the development of the three

variables over time in Portugal can be found in Figure 1.

Figure 1, Portugal: Development of key variables

Tests for reverse causality (from growth to trade and fiscal deficits due

to increased demand, for example) also come up short. When testing Equation

1.1 and 1.3 for Portugal, growth is insignificant in predicting both trade deficits

and fiscal deficits. See Rows 8 and 9 of Table 5. Furthermore, the net effect of

growth on the fiscal balance is positive, suggesting that growth leads to an

improvement in the fiscal balance. The net effect of growth on the trade

balance is negative.


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In Spain, however, the fiscal balance is significant in predicting growth

when Equation 1.2 is run, and the net effect is negative. This equation is run in

first differences, so the evidence for fiscal deficits predicting positive growth is

weaker than if the equation was run in levels. This result could reflect changes

in the business cycle: that large changes in the deficit due to a recession lead

to slower economic growth. The respective p-values can be found in Table 5,

Row 10. Additionally, the causality between growth and the fiscal balance runs

both ways as shown by Equation 1.3 (Table 5, Row 11). When growth changes,

the fiscal balance changes. Growth was insignificant, however, in predicting

the trade balance. See Figure 2 for the development of Spanish growth, the

fiscal balance and trade balance.

Figure 2, Spain: Development of key variables

For the larger Northern economies, Germany and the Netherlands, the

trade and fiscal balances are insignificant in predicting growth as tested in

Equation 1.2. The p-values can be found in Table 5, Rows 1 and 4. Growth

does not predict an improvement in the trade balance or fiscal balance for

Germany as tested in Equations 1.1 and 1.3. However, growth does predict an

improvement in fiscal balances for Germany when Equation 2.3 is estimated.

In the Netherlands, growth was significant in predicting the fiscal balance and

the trade balance (see Table 5, Rows 5 and 6), and the relationship is positive.

It may be the case that macroeconomic balances in the Netherlands are more


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procyclical than in Germany. For the development of key variables over time

in Germany, see Figure 3.

While causality from fiscal deficits to trade deficits is not responsible

for the twin deficits in Portugal and Spain, the third variable influencing them

both is not growth. This result suggests that the trade and fiscal balances run

by these countries have for the most part not been used to import or fund

productive investment. If Portugal and Spain had been running trade deficits

due to the import of productive assets, it should have led to higher growth.

However, it could also be the case that the time span considered in this

analysis was too short to capture this effect. On the other hand, the positive

relationship from growth to the fiscal balance in all of the countries in thesample, except Portugal, suggests that the business cycle plays a large role in

the development of government finances.

Figure 3, Germany: Development of key variables, Model 1

(3)Does growth lead to higher inflation in Eurozone countries? Isthis effect stronger for less-developed, smaller economies?

(H3) Growth Granger causes inflation in all countries in the sample.


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Growth Granger causes inflation in all countries3 except the

Netherlands when Equation 2.1 is tested. There is little difference in the

significance of these estimates, and in two out of the three cases, the

relationship between growth and inflation is positive as expected. There is no

clear evidence that the policy restrictions relating to inflation in the Eurozone

affect smaller economies differently than larger economies. On the contrary,

while growth Granger causes inflation in Portugal, the relationship is negative.

This is a strange result, but could be explained by high historical inflation that

persists despite slowing growth. Baldwin reports Portugal saw slower growth

but higher inflation between 2000-2007 (2010).

(4)Is there a causal relationship between inflation and the budgetdeficit, and is it more significant in smaller Eurozone economiesthan larger economies?

(H4) The fiscal balance Granger causes inflation in Portugal and Spain, butnot in the Netherlands or Germany.

In Portugal and Spain, the fiscal deficit was significant in predicting

inflation at the 1% level when Equation 2.1 is tested. The relationship is

positive; however, the equation is run in first differences, so that changes in

the fiscal balance ratio lead to changes in inflation. The fiscal balance isinsignificant in predicting inflation in the Netherlands and Germany. See

Table 5, Rows 3, 6, 9 and 12 for the p-values for Germany, the Netherlands,

Spain and Portugal, respectively. The development of the key variables of

Model 1 for the Netherlands can be found in Figure 4. The development of the

variables for Model 2 for all countries can be found in Figure 5 below.

3For Spain and Portugal, this equation was run in first-differences, implying that as growthchanges, inflation changes.


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Figure 4, Netherlands: Development of key variables, Model 1


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Figure 5, Development of key variables, Model 2


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Table 5, Granger results: p-value from F-test, Model 1

H0: A does not cause B, reject H0 if p


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The crisis

(H5) The financial crisis will have a significant negative effect on growth, thefiscal balance, the trade balance and inflation for all countries tested.

The crisis has a significant negative effect on growth in Germany, the

Netherlands and Spain when Equation 1.2 is tested. When estimating

Equation 1.3, the crisis has a positive significant effect on the fiscal balance in

Germany. The coefficients and significance of the crisis dummy are shown in

Table 7 below. The effect of the crisis on fiscal balances and inflation was

significant in the Portugal, but negative for fiscal balances and positive for

inflation. In Spain, the fiscal balance is negatively affected by the crisis, but

inflation was positively affected.

Coefficients marked *** are significant at the 1% level, **5%, *10%.

It is surprising that the crisis has significant, positive coefficients on

inflation for Portugal and Spain, although this may have been caused byevents that coincided the crisis, but were not explicitly accounted for in the

regression estimate. It is also surprising that the coefficient on the dummy

variable is positive for Germany when the dependent variable is the fiscal

balance, implying a fiscal improvement during the recession period.

A summary of all the significant Granger causal relationships found is

shown in Table 8 below.

Table 8, Significant results, Models 1 and 2Country Causality Sign

Real growth! Fiscal balance +GermanyReal growth! Inflation +Real growth! Fiscal balance +

Real growth! Trade balance +

Netherlands

Fiscal balance! Trade balance -Real growth! Inflation (d) -PortugalFiscal balance! Inflation (d) +Fiscal balance! Real growth (d) -Real growth! Fiscal balance (d) +Real growth! Inflation (d) +

Spain

Fiscal balance! Inflation (d) +

Table 7, Coefficients on crisis dummyDep. variable Growth Fis/GDP Tb/GDP InfGermany -.0117* .006375** -.006233 .0012

Netherlands -.0074* .00099 -.00126 .001Portugal -.0054 -.011*** -.0039 .003*Spain -.0039*** -.0078*** .0022 .0128***


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6. Conclusion

This paper was written to investigate the effect of current account and

fiscal balances on growth and inflation. If current account and fiscal deficits

were found to predict growth, it would deepen the discussion about the

dangers of macroeconomic imbalances in the Eurozone, because these

dangerous imbalances would also be bearers of future economic growth.

Furthermore, if fiscal deficits were found to cause trade deficits, then policy

discussions about how to improve these imbalances could focus on the fiscal

deficit. By comparing the results between larger and smaller European

countries, the thesis aimed to analyze if the restrictions of the Maastricht

criteria discriminated against countries that experienced catch-up growth. AGranger causal analysis of inflation was also included to test if the relationship

between growth and inflation differed between different economies, and if

excess demand caused by fiscal deficit spending caused inflation in different

types of Eurozone economies.

For the two smaller, Southern European economies investigated, only

Spain provides any evidence of a catch-up phenomenon where fiscal deficits

would affect economic growth, as seen in Table 8. However, fiscal deficits

were not found to cause trade deficits. Furthermore, economic growth also

leads to an improvement of the fiscal balance in Spain. For Portugal, there is

no evidence that fiscal deficits have caused trade deficits over the period 1999-

2010. The source of the twin deficits found in these countries is therefore not

the fiscal deficit. The Netherlands is the only country in which there was

causality from the fiscal balance to the trade balance, but the relationship is

negative. The Netherlands is also the only country in which economic growthpredicts an improvement in the trade balance. In every country except

Portugal, growth leads to an improvement of, or causes changes in, the fiscal

balance. The procyclical result is not surprising. The fiscal balance is defined

as G-T, and T, tax revenue, is an automatic stabilizer that falls during periods

of recession due to higher unemployment and lower corporate profits, and

increases during periods of growth. Growth causes inflation in all Eurozone

economies tested except the Netherlands, but the fiscal balance only causes

inflation in Spain and Portugal.


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In order to determine the best policy to narrow widening

macroeconomic imbalances, a similar analysis should include more countries.

The two representative problem countries used here gave conflicting results

as to whether fiscal deficits predict growth. Ideally, one would include more

countries over a longer period of time. Furthermore, Granger causality should

be tested using different variables. The twin deficits in Spain and Portugal

could be caused by consumption growth or investment. Interesting results

might also be yielded if the trade balance was separated into two variables,

exports and imports, as done in Beetsma, Giuliodori and Klaassen (2007).

Furthermore, this thesis does not investigate the long-run relationship

between budget deficits and trade deficits.

The current results suggest excess inflation in certain Eurozone

countries can be addressed through tighter fiscal policies. There is also

evidence that improving the fiscal balance would not be enough to improve

the current account balance. Moreover, the procyclical behavior of the fiscal

balance serves as a reminder to EU policymakers that SGP reform of deficit

and debt rules should be at least mildly countercyclical (Manassee, 2010).

Economist have warned that the current proposed SGP reform exacerbates

the problem of pro-cyclical adjustment: the debt rule, similarly to the deficit

rule, requires tougher budget cuts the deeper the recession (2010). These

deep required budget cuts during a recession might pose a larger threat to the

stability of the Eurozone than the disparities they are meant to address.

Reform that demands frugal fiscal policy during boom times, when

unemployment is low, could make it easier to bring the Eurozone into balance.


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7. References

Aksoy, Yunus andPiskorski, Tomasz (2006). U.S. domestic money, inflationand output. Journal of Monetary Economics, 53 (2006), 183197.

Baldwin, Richard, Gros, Daniel and Laeven, Luc (2010). Completing theEurozone Rescue: What more needs to be done? Centre for EconomicPolicy Research/A VoxEU.org publication. Accessed 18 June 2011 athttp://www.voxeu.org/reports/EZ_Rescue.pdf

Beetsma, Roel, Giuliodori, Massimo and Klaassen, Franc (2007). The Effectsof Public Spending Shocks on Trade Balances in the European Union.University of Amsterdam working paper. Accessed 2 June 2011 athttp://www.etsg.org/ETSG2007/papers/klaassen.pdf

Blanchard, Olivier and Giavazzi, Francesco (2002). Current Account Deficits

in the Euro Area: The End of the Feldstein-Horioka Puzzle? BrookingsPapers on Economic Activity, 2(2002), pp. 147-186. Accessed 2September 2010 at http://www.jstor.org/sTable/1209205

Edwards, Sebastian (2002). Does the current account matter? PreventingCurrency Crises in Emerging Markets. University of Chicago Press.

Accessed 20 April 2011 at https://www.nber.org/chapters/c10633

Europa. A plain language guide to Eurojargon. Accessed 14 June 2011 athttp://europa.eu/abc/eurojargon/index_en.htm

European Central Bank (1). Inflation differentials in the Euro Area: Potential

causes and policy implications. Accessed 25 July 2010 athttp://www.ecb.int/pub/pdf/other/inflationdifferentialreporten.pdf

European Central Bank(2). Monetary Policy. Accessed 10 June 2011 athttp://www.ecb.int/mopo/html/index.en.html

European Commission. Economic and Financial Affairs, Focus on Inflation:Glossary. Accessed 25 June 2011 fromhttp://ec.europa.eu/economy_finance/focuson/inflation/glossary_en.htm#sgp

Eurostat. Fiscal balances, external (trade) balances. Accessed 25 May 2011 at

http://epp.eurostat.ec.europa.eu/portal/page/portal/government_finance_statistics/data/main_Tables

Fregert, Klas (2004). Chapter 6. Multivariate time series models. PracticalMacroeconomics. Textbook draft. Department of Economics, LundUniversity. Accessed 10 May 2011 athttp://www.nek.lu.se/NEKKFR/Practical%20macro/Practical%20macro.htm

Freund, Caroline (2005). Current account adjustment in industrial countries.Journal of International Money and Finance, 24(2005), pp. 1278-1298.


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Gruber, Joseph W. and Steven B. Kamin (2007). Explaining the global patternof current account imbalances. Journal of Money and Finance (26), pp.500-522.

Hewitt, Gavin (3 June 2011). Jean-Claude Trichet outlines his European

dream. BBC Business News. Accessed 3 June 2011 athttp://www.bbc.co.uk/news/business-13641063

Khalid and Guan (1998). Causality tests of budget and current accountdeficits: Cross-country comparisons. Empirical Economics (1999)24(389)

Lane, Philip R. (2006). The Real Effects of European Monetary Union.Journal of Economic Perspectives. Vol. 20 (4), pp. 4766.

Maddala, G.S. and Kim, In-Moo (2000). Unit Roots, Cointegration, andStructural Change. Cambridge University Press.

Manasse, Paolo (2010). Stability and Growth Pact: Counterproductiveproposals. Accessed 23 June 2011 athttp://www.voxeu.org/index.php?q=node/5632

NBER (2010). Business Cycle Dating Committee. Accessed 20 May 2011 athttp://www.nber.org/cycles/sept2010.html

OECD Stat Extract. Real GDP, inflation, nominal GDP.

Piersanti, Giovanni (2000). Current account dynamics and expected futurebudget deficits: some international evidence. Journal of International

Money and Finance, 19(2000), 255-271.

Rabanal, Paul (2006). Inflation Differentials in a Currency Union: A DSGEPerspective. La Caixa Research Department publication.

Reisen, Helmut (1998). Sustainable and Excessive Current Account Deficits.Empirica 25, 111131. Accessed on 22 May 2011 at

Seater, John J. (1993). Ricardian Equivalence. Journal of Economic Literature31(1993), pp. 142-190.

Studenmund, A.H. (2006). Using Econometrics. Fifth Edition.

Pearson/Addison-Wesley.

Vamvoukas, George A. (1999). The twin deficits phenomenon: Evidence fromGreece. Applied Economics 31(9). 1093-1100.

Zemanek, Holger, Ansgar Belke and Gunther Schnabl (2009). CurrentAccount Imbalances and Structural Adjustment in the Euro Area: Howto Rebalance Competitiveness. DIW Berlin: German Institute forEconomic Research. Discussion paper 895. Retrieved 10 June 2010 athttp://ssrn.com/abstract=1400645


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8. Appendix

Variable definitions

Table 4, Variable definitions

Variable Description Source

growth, y.

Real GDP growth OECD

tb/gdp External trade balance as share of GDP OECD

fis/gdp Fiscal balance as a share of GDP Eurostat

inf," Inflation, consumer prices OECD

CrisisTakes the value of one for the period 2007:4-2009:2, zero otherwise

NBER

Descriptive statistics

Table 1. Germany

Variable | Obs Mean Std. Dev. Min Max

-------------+--------------------------------------------------------

ggrowth | 45 .0028063 .0091117 -.036275 .020897

gfisgdp | 45 -.0208853 .0180847 -.0422084 .0156825

gtbgdp | 45 .0451965 .02024 -.000503 .074818

ginf | 45 .0038275 .0033916 -.0055883 .009497

Table 2. Netherlands


-------------+--------------------------------------------------------

nlgrowth | 45 .0038912 .0074794 -.0240257 .0153659

nlfisgdp | 45 -.011363 .0221732 -.0621295 .0199704

nltbgdp | 45 .0714469 .0117253 .0399683 .0896801

nlinf | 45 .005028 .0052915 -.0089563 .0150485

Table 3. Portugal


-------------+--------------------------------------------------------

pgrowth | 45 .0021601 .0086343 -.0200372 .0221039

pfisgdp | 45 -.0168138 .0403359 -.1153581 .0274867

ptbgdp | 45 -.0875969 .0151843 -.1235012 -.0603103

pinf | 45 .0062294 .0068904 -.0093427 .0180473

Table 4. Spain


-------------+--------------------------------------------------------

spgrowth | 45 .0055013 .0065219 -.0160847 .0150719

spfisgdp | 45 -.0168138 .0403359 -.1153581 .0274867

sptbgdp | 45 -.0383878 .0184347 -.0748099 -.0128128

spinf | 45 .0071972 .0097657 -.0164946 .023791

Note: All values in decimals, not percentages.


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Sensitivity analysis

The models are estimated using Ordinary Least Squares (OLS), and a

White Test is performed to check for heteroskedasticity as in Khalid and Guan(1998). The Breusch-Godfrey test is used to check for serial correlation of theerror term. Augmented Dickey-Fuller tests are performed on each variable tocheck for stationarity. The optimal lag length of each model is determinedusing three commonly used tests: Akaike Information Criterion, SchwarzBayesian Information Criterion and the Hannan-Quinn Information Criterion.

A common problem in this analysis is the presence of higher-orderautocorrelation and non-stationary variables. To correct these issues, firstdifferences or additional lags (see Toma and Yamamoto,1995, as quoted inMaddala and Kim,1998) are used. When using the Toma and Yamamoto

method, only the lag lengths first specified as optimal will be checked forsignificance. In the case of first-order autocorrelation, the Prais-Winstonmethod is used. In terms of non-stationarity, the dummy variable, crisis, has

been ignored. Where heteroskedasticity is found, robust standard errors areused.

Summary of results

Germany

Model 1

For the first Granger specification with growth as the dependentvariable, the regression is heteroskedastic and has no serial correlation. Theoptimal lag order is one. The trade balance and fiscal balance as ratios of GDPare non-stationary, and are corrected by including extra lags of the non-stationary variables into the equation as in Toma and Yamamoto (1995) asquoted in Maddala and Kim (1998).

Results: In the case of Germany, there is no Granger causal relationshipfrom the fiscal and trade balance as a percentage of GDP, to growth. P-valuesfrom the F-tests can be found in Table 5, Row 1. The only variable foundsignificant is the crisis dummy variable (p=.068), and the sign is negative as

expected. The coefficient on the lag of growth has a positive sign, while thecoefficients the fiscal balance and the trade balance are negative. This isconsistent with the first-difference regression. The adjusted R-squared of theequation is 0.2831.

When testing the equation with the fiscal balance as the dependentvariable, the appropriate lag length is given as 3 or 4 depending on the testused. I used three in my analysis per the Schwarz Bayesian InformationCriterion test to preserve degrees of freedom. There is no heteroskedasticity.

At the 5% level, there is first and fourth order serial correlation, and a unitroot is found for the trade balance. After first-differencing the trade balance

variable, all serial correlation and non-stationarity has been eliminated.Adding an extra lag to the equation worsens the serial correlation.


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Results: Growth is significant and positive in predicting inflation(p=0.04). The coefficient of the first lag of growth is 0.1356. The coefficient ofthe fiscal balance is positive and insignificant (p=0.168). The adjusted R-squared of the equation is 0.0677.

NetherlandsModel 1

With growth as the dependent variable, the optimal lag length is one.There is heteroskedasticity and no first-order serial correlation. Robuststandard errors are used in the final regression. The fiscal balance and thetrade balance are non-stationary, and these variables are first differenced inthe final model. When an extra lag of these variables is used, serial correlationof the second order is present.

Results: An F-test shows both the trade balance and the fiscal balance

are insignificant in predicting growth. Both coefficients are positive. Theindividual p-value for the fiscal balance is 0.56 and for the trade balance is0.31. The model's R^2 is 0.4459. The crisis is significant (p-value is 0.059)and negative.

When the fiscal balance is the dependent variable, an optimal laglength of three is found. There is no heteroskedasticity or serial correlation atthe 5 percent level. The trade balance is non-stationary. When the model isfirst differenced, or an extra lag for the trade balance is used, there is no first-order serial correlation at the 5 percent level.

Results: The trade balance is insignificant in explaining the fiscalbalance with a p-value of 0.56. The lags of growth are significant at the 1%level (p-value is 0.0002). The coefficients on growth and the trade balance areall positive. The crisis dummy is positive and insignificant (p=0.59).

When the trade balance is the dependent variable, a lag order of two isoptimal. There is no heteroskedasticity or serial correlation. Growth and thetrade balance have a unit root. When an extra lag is added, there is first-orderserial correlation, so the prais command is used. When the equation is first-differenced, higher-order serial correlation is present, so this method will not

be used.

Results: An F-test on the lags of growth shows significance at the 10percent level (p=0.09) and an F-test on the two lags of the fiscal balance aresignificant at the 5 percent level (p=0.02). The individual coefficients ongrowth and the fiscal balance change sign depending on the lag length, but thenet effect of growth is positive and the fiscal balance is negative. The crisisdummy is negative and insignificant.

Model 2

The appropriate lag length when growth is the dependent variable isone. There is heteroskedasticity, and no first-order serial correlation. The

fiscal balance is non-stationary, and the variable is estimated in firstdifferences to correct for this.


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Results: An F-test shows that inflation and the fiscal balance are notsignificant in predicting growth (See Table 6, Row 4). The coefficient forinflation is negative and insignificant and the coefficient for the first-differenced fiscal balance is positive and insignificant. The crisis dummy,

which has the expected negative coefficient, is significant at the 5% level.

With the fiscal balance as the dependent variable, the optimal laglength is three. There is no heteroskedasticity or serial correlation at the 10percent level. Inflation is non-stationary. The variable is estimated in firstdifferences.

Results: The lags of inflation are jointly insignificant (p=0.33) and thelags of growth are jointly significant at the 1 percent level (p=0.00). Allcoefficients are negative. The crisis dummy is insignificant and positive.

When inflation is the dependent variable, the optimal lag length is four.There is no heteroskedasticity, and no serial correlation at the 5 percent level.

The fiscal balance and inflation are non-stationary. When an extra lag isadded to inflation and the fiscal balance, or they are first differenced, serialcorrelation is still present. However, when the non-stationary variables arefirst-differenced, there is no autocorrelation at the 5% level.

Results: An F-test of all the lags of growth is insignificant with a p-valueof 0.23, and an F-test of the lags of the fiscal balance has a p-value of 0.78. Allthe coefficients on the lags of inflation (except the fourth lag) are negative andsignificant at the 1% level. The signs of the coefficients for the fiscal balanceare inconsistent for different lag lengths, but all insignificant.

Portugal

Model 1

When growth is the dependent variable, the optimal lag length is zerowith or without the dummy variable. One lag will be used in the analysis.There is no heteroskedasticity or autocorrelation. The fiscal balance and thetrade balance have a unit root. Adding extra lags to the fiscal balance andtrade balance leads to serial correlation. The variables are re-estimated in firstdifferences, which corrects the non-stationarity and serial correlation.

Results: No variables are significant in predicting growth for Portugal,

including the first lag of growth (p=0.62), which has a negative coefficient.The coefficient of first lag of the fiscal balance is positive and insignificant

with a p-value of 0.18.

When the fiscal balance is the dependent variable, the optimal laglength is four. There is no heteroskedasticity and no serial correlation at the5% level. Growth, the fiscal balance and the trade balance all have a unit root.

When an extra lag is used, there is no serial correlation at the five percentlevel, so this form will be used. Serial correlation is present at the 5% level

when the model is re-estimated in first differences.

Results: An F-test shows growth and the trade deficit are insignificantin predicting the fiscal balance. The lags of growth are insignificant with a p-


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value of 0.16, and the same test on the trade balance has a p-value of 0.36. SeeTable 5, Row 8.

When the trade balance is the dependent variable, a lag length of one isoptimal. There is no heteroskedasticity, and no autocorrelation.

Results: An F-test reveals the growth and the fiscal balance areinsignificant in predicting the trade balance. See Table 5, Row 9.

Model 2

The appropriate lag length is measured as two or zero depending on thetest. My analysis will rely on the Akaike's Information Criterion and use twolags. There is no heteroskedasticity, but there is second-order serialcorrelation. No variables except for the dummy are non-stationary. When firstdifferences and extra lags are used, no serial correlation is present.

Results: An F-test showed that inflation and the fiscal deficit are notsignificant in predicting growth. See Table 6, Row 7.

When the fiscal deficit is the dependent variable, a lag length of four isoptimal. There is no heteroskedasticity, but there is serial correlation at the5% level for the second, third and fourth lags. Growth, the fiscal balance andinflation have a unit root. These variables are stationary when in firstdifferenced form. When extra lags or the first-differenced form is used, serialcorrelation of one degree and higher is present. Using the both differencedform and extra lags does away with any autocorrelation.

Results: Neither growth nor inflation is significant in predicting the

fiscal balance. See Table 6, Row 8. The crisis coefficient is significant at the 1percent level and negative.

When inflation is the dependent variable, a lag length of four isoptimal. There is no heteroskedasticity, but there is serial correlation up to thefifth order. Growth, the fiscal balance and inflation all have a unit root. Whenthe variables are first-differenced, they are stationary at the five percent level,

but there is still autocorrelation. When the equation is first-differenced, andan extra lag is added, then there is only first-order serial correlation and theprais command is used.

Results: An F-test confirms both growth and the fiscal balance aresignificant in explaining inflation. See Table 6, Row 9. The crisis is positiveand significant at the 10 percent level.

Spain

Model 1

When growth is the dependent variable, the optimal lag length is four.There is no heteroskedasticity, but there is autocorrelation of the first andfourth order at 5 percent. The fiscal balance, trade balance and growth have aunit root. Running the model in first differences eliminates autocorrelation.


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Results: The lags of the differenced trade balance variable are jointlyinsignificant with a p-value of 0.26. An F-test of the lags of the differencedfiscal balance is jointly significant at the 1% level. The net effect of the fiscal

balance on growth is negative. The crisis is negative and significant at the 1%level (p-value of 0.001).

When the fiscal balance is the dependent variable, four lags areoptimal. There is no heteroskedasticity, but there is serial correlation up to thefourth level. Growth, the fiscal balance and the trade balance all have a unitroot. When the model is run in first differences, the serial correlation iscorrected.

Results: An F-test of all the differenced lags of growth is significant atthe 1 percent level, and the same test on the lags of the trade balance areinsignificant with a p-value of 0.93. The net effect of growth is positive. Thecrisis dummy is negative and significant at the one percent level.

When the trade balance is the dependent variable, one lag length isoptimal. There is heteroskedasticity and no serial correlation. Growth, thefiscal balance and the trade balance have a unit root. When an extra lag isadded to the equation, serial correlation is no longer a problem.

Results: The coefficient on the first lag of growth is negative andinsignificant. The coefficient on the first lag of the fiscal balance is alsonegative and insignificant. The crisis dummy is positive but insignificant. SeeTable 5, Row 12 for details.

Model 2

When growth is the dependent variable, the optimal lag order is four.There is no heteroskedasticity or serial correlation. Growth and the fiscal

balance have a unit root. These variables are first differenced in the finalspecification, because adding extra lags to the equation leads to serialcorrelation.

Results: An F-test of only the lags of inflation is insignificant with a p-value of 0.18. An F-test of all the lags of the fiscal balance is significant with ap-value of 0.03. The net effect of the fiscal balance is positive. The crisisdummy is significant at the one percent level and negative.

When the fiscal balance is the dependent variable, the optimal laglength is four. There is no heteroskedasticity, but there is serial correlation inthe first, third and fourth degree. Growth and the fiscal balance have unitroots. When first differences are used, there is no serial correlation at the fivepercent level.

Results: An F-test of the four lagged differences of growth is significantwith a p-value of 0.01. The same test on the four lagged differences of inflationis insignificant with a p-value of 0.55. The crisis dummy is negative andsignificant.

When inflation is the dependent variable, the optimal lag length is four.There is no heteroskedasticity, and there is first and fourth order serial


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correlation. Growth and the fiscal balance are non-stationary. When theequation is first differenced, there is first-order autocorrelation, so the praiscommand is used.

Results: An F-test on the lagged differences of the fiscal balance alone

is significant at the one percent level, and the same test on the laggeddifferences of growth are also significant at the 1 percent level. See Table 6,Row 12. The coefficient on the crisis dummy is positive and significant at the1% level.

out of balance: the effects of current account and fiscal balances on growth and inflation in the...

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