An empirical analysis of the twin deficits evidence from Sri Lanka

Abstract

This paper explores the empirical relationship between budget and current account deficits in the case of a small developing country, Sri Lanka for the period of 1960-2010. The data are collected from annual reports, Centra! Bank, Sri Lanka. The econometric methods used in this study are cointegration technique, Error correction modeling and Granger causality analysis. The empirical results are consistent with conventional view. Our empirical results clearly suggest that there exist statistically significant long-run positive relationship between the trade deficit and the budget deficit in Sri Lanka. The Granger causality test shows that the direction of causality runs from the budget deficit to the trade deficit and the relationship is positive and statistically significant. '••The empirical analysis in this study partially supports the Keynesian view that there is a linkage between the trade deficit and the budget deficit and the direction of causality is correct but the Ricardian equivalence hypothesis is not valid for Sri Lankan economy during the study period.