Assessment, Interaction and the Transmission Process of Twin deficit Hypothesis: Fresh Evidence from India

Abstract

In light of the persistent and coinciding internal and external imbalances, there remains an argument that worsening balance of payment (BoP) is the result of higher fiscal imbalance. However, no concrete consensus either theoretical or empirical exists, particularly in the context of India, and, therefore, this phenomenon of the twin deficit hypothesis becomes more of an empirical question. This study makes a timely and fresh revisit, especially in the backdrop of the fiscal expansions, to curb the recent recessionary situation that is engulfing the economy. To this end, an econometric exercise is undertaken on a quarterly data of financial year over 2000–2019. This work also extends the analysis with three reference variables, namely gross domestic product (GDP), private investment to GDP, real effective exchange rate together with the data for three dummy years to capture the impact of their specific occurrence in a particular year. The transmission mechanism describes how the budget deficit transcends and affects external sector variables. Empirical findings suggest a strong positive association between the budget deficit and current account deficit (CAD), which reinforces the validity of Mundell–Fleming and Keynesian theories. The effect of different exogenous variables explicitly indicates a simultaneous action on multiple fronts to improve the twin account balance.