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Twin Deficits Or Distant Cousins? Evidence From India, Artatrana Ratha

Economics Faculty Working Papers

The twin-deficits theory has intrigued economists and policy-makers alike for the past few decades. In a Keynesian economy, budget deficit increases the absorption of the economy, causes import expansions, and thereby, worsens the trade deficit. It also causes domestic interest rates to rise, domestic currency to appreciate, and thereby, contributes to trade deficits. However, according to the Ricardian Equivalence Hypothesis (REH), rising budget deficits implies higher future tax-liabilities so people would save more and consume less. As a result, an inter-temporal shift between taxes and budget deficits would have no impact on the real interest, or the trade deficit. Thus, …