ISSN (Print) - 0012-9976 | ISSN (Online) - 2349-8846

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Does Fiscal Deficit Influence Trade Deficit?

Economic theory provides two alternative hypotheses regarding the relation between the budget deficit and the trade deficit of a country. The twin deficit hypothesis claims that a budget deficit causes a trade deficit. At the other extreme, the Ricardian Equivalence Hypothesis (REH) rejects any possible relation between these two deficits. This paper undertakes an econometric exercise to study the impact of the fiscal deficit on India?s external accounts since the mid-1980s and finds an absence of cointegration between the two deficits. Further, an absence of cointegration between the savings rate and the fiscal deficit-GDP ratio also negates the REH in Indian circumstances. These findings suggest that the ratios of trade deficit, fiscal deficit and net savings randomly maintain the national income identity and that a high fiscal deficit has been sustained by a simultaneous and independent increase in the savings ratio. Given that the savings-income ratio is already at a high level, a further increase cannot be taken for granted. However, notwithstanding the absence of a twin deficit so far, the situation offers no scope for profligacy in fiscal behaviour, both for the centre and the states.

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