Federal Reserve and Monetary Policy: The Twin Deficits

See: Remarks by Governor Edward M. GramlichAt the Isenberg School of Management Seminar Series, Amherst, Massachusetts May 14, 2004
Presented at the Los Angeles Chapter of the National Association for Business Economics Luncheon, Los Angeles, California March 31, 2004
Presented at the Euromoney Bond Investors Congress, London, EnglandFebruary 25, 2004
Budget and Trade Deficits: Linked, Both Worrisome in the Long Run, but not Twins

I'm not going to go to much into this. It is a complex subject, however I'm going to apply Keynes implied expanded community to this simple equation (See Federal Reserve and Monetary Policy: Greenspan's speech on Capital Hill was as I feared.) :

Original: NS = S - BD = I – TD

The expanded community the is no Trade Deficit (TD), but there can be a Government Budget Deficit (BD). This means that the National Savings (NS) is the combination of the US community and the off-shored (expanded) community. This same combination argument can be applied to Savings (S) and Investments (I).

I'm going to add a simple production function F(i(1), i(2), ..., i(m)) and use the concave rule: if f(x) > f(x'), then f(yx + (1 – y)x') > yf(x) + (1 – y)f(x') for any y E (0, 1).

In words; The output (GDP) of the US community [f(x)] is greater than the output (GDP) of the off-shored (expanded) community[f(x')]. Therefore the weighted combination of the two “communities” is inside the isoquant of the production function. This is economically inefficient. To bring it back onto the isoquant (technology efficient) and therefore make it economic efficient, one needs to add a condition of throwing away the extra input. I'm going to say that this thrown away part is the US output, hence it is the US's community's “trade gap”. See figure 1.

Figure 1

I'm giving the US community and the off-shored (expanded) community a progressive tax system. There is no tax revenue sharing between the two communities implies that a part of the off-shored (expanded) community's tax is paid by the US community without a reciprocal payment. This implies that the thrown away input is not counted. Therefore, the US trade deficit and the US government debt are in fact twins.