A Test of the Twin Deficits Hypothesis for the Kenyan Economy

Abstract

This study examines the Twin Deficit Hypothesis (TDH), which posits that a government’s fiscal deficit occurs together with current account deficit through demand, interest rate and real exchange rate effects. The Keynesian theory and Mundell–Fleming framework prove the existence of the twin deficit relation, whereas the Ricardian equivalence theory negates any such relationship. Empirically also, certain studies prove the existence of the twin deficit relation, whereas several others challenge and prove that the two deficits have no relation with each other. This study therefore sought to test the Twin Deficit Hypothesis within the Kenyan context. Data was obtained from the International Financial Statistics and the World Economic Outlook of the International Monetary Fund (IMF). The data spans the period 1980-2017. An ARDL model was implemented to test the validity of the hypothesis. ARDL was preferred given the short span of data and the model’s suitability for small samples. The findings indicate that budget deficits have direct positive effects on the current account. These effects are significant at 1% level of significance. The indirect effects of budget deficits on the current account are also strong. Budget deficits, interest rate and the exchange rate have significant effects on the current account. An increase in budget deficits increases interest rates and appreciates the exchange rate. This leads to deterioration of the current account. Thus the real exchange rate has highly significant effects on the current account. The conclusion is that budget deficits and the exchange rate dominate in explaining movements in the current account in the long run. The results support the Mundell-Fleming model and the twin deficit hypothesis.

Keywords: Twin Deficit Hypothesis, Mundell-Fleming Model, Budget Deficit, Current Account

DOI: 10.7176/JESD/13-4-06

Publication date: February 28^th 2022