Title: Twin Deficits Phenomenon in Maldives: Spectral and Time Domain Analysis of Time Series
Abstract: There has been a plethora of studies concerning the relationship between budget deficit and trade deficit. The overall findings can be classified under two broad hypotheses. One is known as the 'twin deficit hypothesis', which implies that there does exist a relationship between budget deficit and trade deficit and budget deficit Granger causes trade deficit. On the other hand, there is an alternative hypothesis known as 'Ricardian equivalence theorem', which negates any such relation. This study seeks to test these hypotheses and examine the nature as well as the direction of causal relation between budget deficit and trade deficit in the economy of Maldives, by using real budget deficit and trade deficit data series. This study is based on a battery of tests, such as ADF and PP unit root tests and correlogram, followed by the estimation of cointegration, VECM, Granger causality through VAR model and spectral analysis. The findings of the study support the Ricardian equivalence hypothesis for the economy of Maldives over the period of the study. (ProQuest: ... denotes formulae omitted.) Introduction The most important event in the history of international economics during the 1970s, was the breakdown of 'fixed exchange rate' system and the adoption of 'flexible exchange rate' system instead. It was significant because it spelled the end of the spirit of 'Bretton Woods System' as incorporated in the IMF Chapter. With the adoption of flexible exchange rate system since the 1970s, another important event emerged, known as the 'twin deficits phenomenon' in economic literature. The phenomenon of 'twin deficits' is a recent development in macroeconomic structure of trading economies. Its origin dates back to the 1980s when flexible exchange rate virtually replaced the system of fixed exchange rate. The simultaneous upsurge of the budget deficit and trade (current account) deficit in a relatively large number of countries was observed in the 1980s. The close correlation observed between these two deficits is usually known as twin deficits. Twin deficits, therefore, refer to the long-run relationship between 'budget deficit' and 'trade deficit' (or current account deficit). The proposition that budget deficit has positive and significant effect on trade deficit is usually referred to as 'twin deficit hypothesis'. The hypothesis basically implies that the main cause of trade deficit is the excessive budget deficit. However, some economists also argue that budget deficit may also be the resultant of trade deficit. Consequently, the direction of causality between these two macroeconomic variables appears to be a subject of contention among the economists. Twin Deficits: Theoretical Basis A simple study of the national income identity of any open economy exhibits a link between budget deficit and trade deficit. The identity is: ... (1) where, Y = National income, C = Consumption, I = Investment, G = Government expenditure X = Export, M = Import, and (X - M) = Net export. From Equation (1) we have: ... (2) where, S^sub p^ = Private Savings S^sub pub^ = Public Savings S = National Savings = S^sub p^ + S^sub pub^ Equation (2) states that national savings, which is the sum of private savings (S^sub p^ = Y - T - C) and public savings (S^sub pub^= T - G) equals investment plus net export (X - M). From Equation (1) we further obtain: ... (3) where (M - X) implies 'trade deficit' when M > X, and (G - T) implies 'budget deficit' when government expenditure exceeds tax revenue (i.e., G > T). Equation (3) states that trade balance is virtually the sum of investment - savings gap and the 'budget deficit'. Thus, given a stable investment - savings gap, an increase in budget deficit raises the trade deficit. Thus, Trade Deficit = Excess of Investment over Savings + Budget Deficit An economy requires the equality between investment and savings for reaching equilibrium. …
Publication Year: 2010
Publication Date: 2010-04-01
Language: en
Type: article
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Cited By Count: 6
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