An Empirical Investigation for the Twin Deficit Hypothesis in Nepal

Abstract

The debate over the validity of Twin Deficit Hypothesis which advocates in favor of long run causal relationship between budget deficit and trade deficit has lasted for several decades. However, in opposition to this hypothesis is Ricardian Equivalence Theory which argues that budget deficits don’t lead to trade deficit in the economy. Hence, this study intends to test the validity of Twin Deficit Hypothesis for Nepalese economy. The major objective of this study is to examine the relationship between budget deficit and trade deficit in case of Nepal. ARDL technique of cointegration, bound testing, error correction model and Granger causality test have been employed to examine the relationship between the budget deficit and trade deficit using the time series data from 1987/88 to 2017/18 collected from secondary sources. Apart from budget deficit and trade deficit, other variables included in the model are real exchange rate, openness of trade and inflation. It is found that trade deficit has an increasing trend over time whereas budget deficit has increasing trend with periodic fluctuations. ARDL model estimates and bound test discard any cointegration between budget deficit and trade deficit which indicate no long run relationship among the variables. Error correction model suggests the absence of short run relationship between budget deficit and trade deficit. Furthermore, Granger causality test also shows that there doesn’t exist any significant causal relationship between budget deficit and trade deficit in any direction. Twin Deficit Hypothesis is not found to be valid for Nepal during the study period and thus, Ricardian Equivalence Theory is found to be valid.