Twin Deficits or Twin Divergent: An Inquiry of Keynesian and Ricardian View in the Case of Sri Lanka

This study analyses the causal relationship between budget deficit and current account deficit, and the validity of Keynesian and Ricardian views in the Sri Lankan context. The study employed annual time series data for budget deficits, current account deficits, interest rates, real GDP growth rate, and real exchange rates of Sri Lanka over the period of 1977 to 2022. The Auto Regressive Distributed Lag (ARDL) model was employed to identify long-run and short-run dynamic relationships between the variables. The findings revealed that a higher fiscal deficit widens the current account deficit in Sri Lanka in both the short-run and long-run during the post-liberalisation period. The Granger causality test also detected a unidirectional causation running from budget deficit to current account deficit in Sri Lanka. Thus, the empirical results in this paper support the Keynesian view regarding the linkage between the current account deficit and the budget deficit and the potential absence of a strong Ricardian equivalence effect in the case of Sri Lanka. The study found that the short-run relationship between budget deficit and current account deficit is smaller than the long-run effect. Real exchange rate appreciation increases the current account deficit significantly in the long run by reducing exports and increasing imports. Although the interest rate does not have any significant impact on the current account deficit in the long run, it has a significant negative impact in the short run, as expected. The current account deficit widens significantly with the lower economic growth rate in both the short-run and long-run.