Twin deficits in small open baltic economies

Abstract

This paper analyzes the twin deficit hypothesis - simultaneous current account deficit and budget deficit - in three small open Baltic countries (Estonia, Latvia and Lithuania) running under certain forms of the fixed exchange rate regime. The idea of twin deficits is tested using the vector error correction model (VECM), Granger causality tests and forecast variance decomposition, involving three variables: current account, budget balance, and investments. The new estimates confirm significant long-run positive relation between budget balance and current account in Estonia and Lithuania on one hand and the negative one in case of budget balance and investments in all three considered countries. The results of the analysis are specific to each country as they depend on their particular macroeconomic background. The contribution was elaborated within the project VEGA 1/0973/11.