The Effect of Budget Deficit on Current Account Deficit in Ethiopia: Investigating the Twin Deficits Hypothesis

Abstract

This study investigated the relationship between government budget deficit and current account deficit in Ethiopia using annual data spanning the period 1976-2015. The analysis is based on a vector error correction model. The methodology of the study begins with Augmented Dickey-Fuller stationary tests of the data and the Johansen co-integration rank test that revealed current account, budget deficit, real gross domestic product and real effective exchange rate to be co-integrated with two co-integrated relationship and thus share long-run equilibrium relationships. Empirical result from the vector error correction model (VECM) suggests that budget deficit is negatively related with the current account deficit, though statistically insignificant. Despite the VECM result, the outcome of the Granger causality test reveals the existence of bi-directional causality between current account deficit and government budget deficit at 5% level. Consequently, the major policy implication of this study is adoption of sound economic policies which plays a pivotal role at boosting the internal government revenue and the export sector by taking the macroeconomic realities of the country into account.