Does Fiscal Deficit Affect Current Account Deficit in India? An Econometric Analysis

Abstract

The aim of this article is to examine the validity of the Keynesian proposition and Ricardian equivalence (RE) theorem for the developing country India over the period 1990–2015. The Mundell–Fleming model and Feldstein chain model which revolve around the Keynesian proposition argues it is budget deficit (BD) which influences current account deficit (CAD), with the increase in interest rate. While as RE theorem states that there is no relationship between BD and CAD, the decrease in tax rates will not increase the consumption because rational agents consider today’s deficit financing as tomorrow’s liabilities. The article initially investigates the theoretical foundation, followed by empirical literature, and uses various methods of econometrics to testify its validity. A co-integration and vector error correction model (VECM) model validates the existence of long-run relationship. The results of Granger causality test reveal the existence of bi-directional causality between BD and CAD and validates Keynesian proposition in India. Our results conclude that instability in macro variables such as inflation, exchange rate, interest rate and money supply (MS) causes CAD and BD which further have been proved by Cholesky decomposition method. However, it has been said in the global economic world that no one can escape the windfall effect of exchange rate volatility and rising prices, and such effects can be minimised but not eliminated. JEL: E12, E31, E52, E62, E63, E41