3. THEORETICAL MODEL
To illustrate the relationship between the government’s fiscal policy and foreign current account balance, by
using Keynesian aggregate demand and supply model for a small open-economy country, we construct a model
for comparing twin deficit hypothesis (TDH) against Ricardian equivalence hypothesis (REH).
Consider national income equation as below:
Y C I G NX
(1)
Where Y stand for gross domestic product or aggregate demand, C for private consumption, I for gross
investment expenditure, G for government expenditure and NX for net export.
On the other hand, aggregate supply is:
Y C S T
(2)
Where S is private saving and T is taxes or mandatory saving.