A consensus has not yet emerged about the relationship between budget deficit, external deficit and national saving. According to mainstream economic literature, the budget deficit can cause an insufficiency of national saving for a given investment rate. In such cases, the investment rate will not be reduced if foreign saving is absorbed, thus causing an external deficit. This is the twin deficits hypothesis. This study seeks to test the hypothesis that the budget deficit causes a external deficit because it causes the appreciation of the real exchange rate. This paper concludes that there is no regular causal relationship between budget deficits and external deficits. This conclusion is empirically conformed by means of estimating a panel data model for 35 countries during the 1991-2000 period.
twins deficits; real exchange rate; panel data
