Twin deficit hypothesis and reverse causality: A case study of China
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Date
2019
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Publisher
Palgrave Communications
Abstract
This paper analyses the causal relationship between budget deficit and current
account deficit for the Chinese economy using time series data over the period of 1985–2016.
We initially analyzed the theoretical framework obtained from the Keynesian spending
equation and empirically test the hypothesis using autoregressive distributed lag (ARDL)
bounds testing and the Zivot and Andrew (ZA) structural break for testing the twin deficits
hypothesis. The results of ARDL bound testing approach gives evidence in support of longrun
relationship among the variables, validating the Keynesian hypothesis for the Chinese
economy. The result of Granger causality test accepts the twin deficit hypothesis. Our results
suggest that the negative shock to the budget deficit reduces current account balance and
positive shock to the budget deficit increases current account balance. However, higher effect
growth shocks and extensive fluctuation in interest rate and exchange rate lead to divergence
of the deficits. The interest rate and inflation stability should, therefore, be the target variable
for policy makers.