Dynamics of Twin Deficits: An Enquiry of the Mundell–Fleming Proposition for India

Abstract

Twin deficits have appeared as the indispensible reality of the Indian economy since long. The study is an attempt to trace out the inherent dynamics of India’s twin deficits problem, particularly to unveil its transmission mechanism. Applying annual secondary data for the period 1971 to 2019, the endeavour reveals India’s twin deficits encounter to follow the path prescribed by the Mundell- Fleming open economy IS-LM model. However, India’s realization is found to differ slightly from the standard theoretical manifestation. In India, domestic exchange rate is found to appreciate followed by the expansionary fiscal policies of the government. The improved exchange rate, owing to the sterilization policies of the monetary authority to uphold the country’s trade competitiveness, is observed to augment India’s domestic interest rate. Again, the increased interest rate, due to its positive effect on the financial inflows, is found to deteriorate India’s external balance. JEL Classification: H6, F32, F31, F21, E43