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A Dynamic Analysis of the Twin-Deficit Hypothesis: the Case of a Developing Country

A Dynamic Analysis of the Twin-Deficit Hypothesis: the Case of a Developing Country The main economic challenge is rising aggregate demand, which leaves the economy short on resources and leads to expanding fiscal and external account deficits. The current study uses autoregressive distributed lag (ARDL) model to evaluate the twin deficit hypothesis in the context of Pakistan in an effort to find an answer to this question. The study uses augmented ARDL, popularized by McNown et al. (Appl Econ 50:1509–1521, 2018) and Sam et al. (Econ Model 80:130–141, 2019), to address the degenerate problems that might arise while applying the ARDL approach. Two separate models were estimated, one with the current account balance as the dependent variable and the other with the balance of trade. In the long run, both models confirm the conventional interpretation of twin deficit hypothesis in Pakistan, with the causality running only from the fiscal deficit to the balance of trade. Other control variables in both models are crucial in understanding the current account balance and balance of trade. According to models, an increase in the exchange rate, as measured by the log of the nominal effective exchange rate, improves both current account and trade balance, verifying the elasticity approach in the long run. The openness of the economy is found to worsen current account balance, and the result is statistically significant. Contrarily, openness has been improved trade balance, but the result is statistically insignificant. To control a large and persistent external deficit, the government has to reduce its fiscal deficit, and such a strategy would be successful when monetary policy is accommodative. http://www.deepdyve.com/assets/images/DeepDyve-Logo-lg.png Asia-Pacific Financial Markets Springer Journals

A Dynamic Analysis of the Twin-Deficit Hypothesis: the Case of a Developing Country

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References (96)

Publisher
Springer Journals
Copyright
Copyright © The Author(s), under exclusive licence to Springer Japan KK, part of Springer Nature 2023. Springer Nature or its licensor (e.g. a society or other partner) holds exclusive rights to this article under a publishing agreement with the author(s) or other rightsholder(s); author self-archiving of the accepted manuscript version of this article is solely governed by the terms of such publishing agreement and applicable law.
ISSN
1387-2834
eISSN
1573-6946
DOI
10.1007/s10690-023-09405-y
Publisher site
See Article on Publisher Site

Abstract

The main economic challenge is rising aggregate demand, which leaves the economy short on resources and leads to expanding fiscal and external account deficits. The current study uses autoregressive distributed lag (ARDL) model to evaluate the twin deficit hypothesis in the context of Pakistan in an effort to find an answer to this question. The study uses augmented ARDL, popularized by McNown et al. (Appl Econ 50:1509–1521, 2018) and Sam et al. (Econ Model 80:130–141, 2019), to address the degenerate problems that might arise while applying the ARDL approach. Two separate models were estimated, one with the current account balance as the dependent variable and the other with the balance of trade. In the long run, both models confirm the conventional interpretation of twin deficit hypothesis in Pakistan, with the causality running only from the fiscal deficit to the balance of trade. Other control variables in both models are crucial in understanding the current account balance and balance of trade. According to models, an increase in the exchange rate, as measured by the log of the nominal effective exchange rate, improves both current account and trade balance, verifying the elasticity approach in the long run. The openness of the economy is found to worsen current account balance, and the result is statistically significant. Contrarily, openness has been improved trade balance, but the result is statistically insignificant. To control a large and persistent external deficit, the government has to reduce its fiscal deficit, and such a strategy would be successful when monetary policy is accommodative.

Journal

Asia-Pacific Financial MarketsSpringer Journals

Published: Apr 29, 2023

Keywords: Twin-deficit hypothesis; Exchange rate; Fiscal policy; Monetary policy; ARDL

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