An Empirical Investigation of the Twin Deficit Hypothesis: Evidence from Sri Lanka

Abstract

Theoretical and empirical evidence proves that prolonged fiscal expansions contribute to current account imbalances and hence, there exists a positive-long run relationship between budget deficits and current account deficits. This relationship is referred to as "twin deficit hypothesis." Significant fiscal expansions and external imbalances, which caused macroeconomic instability in a large number of advanced countries and emerging countries, have motivated examining the issue of twin deficits. Like many other emerging countries, for a long period of time, Sri Lankan economy has been experiencing persistently high budget deficits and current account deficits. In this study, we attempt to explore the twin deficit hypothesis interacting with key financial variables using both annual and quarterly data for Sri Lanka and employing multivariate empirical methodology. We find evidence for long run relationships between twin deficits in Sri Lanka. At the same time, we detect unidirectional causation between twin deficits, which enables into draw several policy implications.