Impact of U.S. Twin Deficits on Bilateral Exchange Rates: Canada and China

This paper examines the U.S. twin deficits debate from a bilateral exchange rate with Canada and China and their respective international reserves angle. This one-lag dynamic linear model is based on the Euler equation expressed in a rational expectations component for aggregate consumption. Findings indicate that the variations in budget deficit had much less impact on the volatility in bilateral U.S.-China exchange rates than those for U.S.-Canada. The U.S. budget deficit variations tend to affect the variations in China's international reserves but not in Canada's. One reason is the near-fixed peg regime in the bilateral U.S.-China exchange rate during the study period of 1990 through 2008.