An empirical analysis of the twin deficit hypothesis: the case of Sri Lanka

Abstract

Prolonged fiscal deficit is one of the leading causes behind many economic disruptions in a country, including current account imbalances. Hence, the purpose of this study is to examine the existence of the Twin Deficit Hypothesis (TDH) in Sri Lanka from 1977 to 2020 and to test the validity of Keynesian and Ricardian views in the Sri Lankan context. Using Autoregressive Distributed Lag (ARDL) model, the study found a short-run and long-run relationship between budget and current account deficit. The empirical results support the Keynesian proposition, thus revealing unidirectional causation from the budget deficit to the current account deficit in Sri Lanka. Further, the study found that the short-run relationship between budget deficit and current account deficit is smaller than the long-run effect. Accordingly, Sri Lanka could reduce the current account imbalances using appropriate fiscal reforms designed to reduce the fiscal deficit.