THE STRUCTURAL RELATIONSHIP BETWEEN FISCAL DEFICIT AND CURRENT ACCOUNT DEFICIT IN INDIA: SVAR ESTIMATION OF THE TWIN DEFICIT HYPOTHESIS

Abstract

This paper tests the validity of the twin deficit hypothesis, the causal relationship between fiscal deficit (FD) and current account balance (CAB), in India for the period 1994-2016 by estimating a structural model that includes the interest rate and exchange rate as an interlinking variable. The SVAR estimates show a negative effect implying that a positive shock given to FD worsens the CAB. The current account deficit, while not directly determined by fiscal deficit, is significantly influenced by RIR and REER. The IRF indicates that a positive shock to FD leads to an increase in the domestic interest rate which appreciates the real exchange rate of the domestic currency making the exports costlier and imports cheaper and thereby widening the current account deficit. The SVAR, IRF and Granger causality analyses show that fiscal deficit affects the current account balance in India through the interlinking variables RIR and REER for the time period 1994 (quarter-I) to 2016 (quarter-IV). This result validates the relevance of the twin deficit hypothesis in the Indian economy and is consistent with the Keynesian proposition in the Indian economy during the study period.