Sample Midterm Answer Key
Please note that the sample midterm is longer that the actual midterm
Discuss the effects of government deficits on the current account.
See pages 306–307 A hard and difficult issue. During the Reagan administration,
the creation of twin deficits, where by slashing taxes, government deficits
increased, which was accompanied with increased current account deficits.
Using the identity, CA
Private Saving – I – (G – T), one can see that if private
savings and I are constants, an increase in the deficit, namely an increase in (G –
T), necessarily increases the CA deficits by the same magnitude.
However, government budget deficit may change both private savings and
investment, thus avoiding a creation of the twin deficits. An example is the
European countries reducing their budget deficits just prior to the introduction of
the euro in January 1999. Now, under the “twin deficits: theory, one would have
expected the EU’s current account surpluses to increase. This has never
happened. The main reason was sharp reduction in private saving rates.
A good answer should discuss Ricardian equivalence that argues that when the
government cut taxes and raises its deficit, consumers anticipate that they will
face higher taxes later to pay for the resulting government debt. In anticipation,
they raise their own private saving to offset the fall in government saving. In
addition, one should mention wealth effect in anticipation of one Europe, assets
prices increased, lowering private saving rates.
“The Balance of payments is always balanced.” Discuss
True. Every international transaction automatically enters the balance of
payments twice, once as a credit and once as a debit.
Explain how government deficits fell yet current account surpluses remained the same in
the EU prior to adopting the euro. Also explain this in the context of the “twin deficits”
Current accounts didn’t change due to a sharp fall in the private saving rate,
which declined by about 4 percent of output, almost as much as the increase in government
saving. The behavior of private savers neutralized the government’s efforts to raise national
saving. The twin deficits theory, the idea of government deficit coupled with a sharply
increased current account deficit, expects the EU’s current account surplus sharply as a
result of the fiscal change.
Explain the concept of Ricardian equivalence.