Fiscal policy, productivity shocks, and the U.S. trade balance deficit

A two-country Real Business Cycle (RBC) model is used to study the behavior of the United States trade balance. In this model, economic fluctuations are driven by productivity shocks and by variations in government purchases and in distorting taxes. The model is simulated using quarterly data on total factor productivity, government purchases, and the average tax rate in the seven major industrial countries during the period 1975–91. A version of the model that postulates complete international asset markets—as frequently assumed in the International RBC literature (see, e.g., Backus, Kehoe, and Kydland 1992)—fails to explain the observed behavior of the U.S. trade balance. In contrast, a version with incomplete asset markets, in which only debt contracts can be used for international capital flows, tracks the behavior of the U.S. trade balance fairly closely.