Current Institutional Affiliation
Professor/Director, Graduate School of Economics/Institute of Economic Research, Nagoya City University

Award Information

Abe Fellowship 2007
Institutional Affiliation (at time of award):
Assistant Professor, Faculty of Economics, Chiba Keizai University
The Optimal Monetary and Fiscal Policy Mix in Economies with Twin Deficits and Twin Divergence

According to some empirical research, the economies of OECD nations are not homogeneous in terms of the effects of fiscal policy on current accounts. Although the textbook “twin deficits” hypothesis, which was based originally on the experience of the US economy, has now been proved by data from almost all OECD countries, more recent US data contradicts it. Under normative theory, which can explain twin deficits well, fiscal deficits result in trade balance deficits. US data, however, show that improvements in fiscal balance create trade balance deficits. This is “twin divergence” rather than twin deficits. When seeking an optimal monetary policy rule from the viewpoint of maximizing social welfare, researchers and policy authorities should consider the existence of this one OECD economy exhibiting twin divergence. However, there are no appropriate models that consider this phenomenon thoroughly. It is recognized by many researchers that optimal monetary policy should be derived with the assumption of international repercussions; however, non-Ricardian fiscal policies that cause twin divergence have not been considered. Also, non-Ricardian fiscal policy is generally considered under the assumption of a closed economy, and thus the international repercussions of fiscal policies that cause twin divergence have not been considered. Recent theories of optimal monetary policy have strong implications for policy implementation. Authorities may be making decisions based on inappropriate economic theory. Developing an appropriate model for deriving an optimal policy rule in economies with a mixture of twin deficits and twin divergence is thus an urgent task. To improve on the weaknesses of preceding papers, mentioned above, a first step in this project will be developing a model to design this optimal policy rule. Once a model with this mixture of twin deficits and twin divergence is developed, the optimal policy rule for maximizing social welfare, not only for each country but also for the world, will be determined theoretically. Determining an optimal policy rule is the most important goal of this research project. This optimal rule, derived from the social welfare maximization problem, will be compared with ad hoc but plausible policy rules, which will then be ranked according to their effects on social welfare. Next, the effects of this optimal rule on actual OECD economies will be empirically investigated, after the appropriateness of the theoretical model is confirmed. The project’s theoretical and empirical analyses are expected to indicate the importance of a mix of monetary and fiscal policies, which has not been sufficiently addressed by recent macroeconomics literature. The expected results are as follows. Optimal policy rules in not only a twin-deficit economy but also in a twin-divergence economy will suggest that both monetary and fiscal policy are needed to maximize social welfare. It will be shown that improvements in social welfare under this rule are immense in contrast to the actual policy rules adopted by authorities in OECD countries. The results of this research project are expected to be in striking contrast to those of other recent papers.