Testing the twin deficit hypothesis for Kenya 1970-2012
Njoroge, Erastus Kaiba
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Macro-economic theory suggests that there exists a causal relationship running from Budget Deficit to Current account deficit a concept normally referred to as the Twin Deficit Hypothesis (TDH). This claim has more often than not been the subject of debate in the scholarly and policy front. Majority of existing literature on the twin deficits hypothesis focuses on its relevance in already developed economies. Further, existing literature has concentrated on analyzing the TDH on a bivariate approach using annual data. This study sought to investigate the relevance of the TDH nexus for Kenya using quarterly data in a multivariate approach which included budget deficits, current account balance, interest rates and exchange rates. The study analyzed quarterly data for a four decade period spanning from 1970Ql - 2012Ql. To estimate if a relationship exists between the variables, the proposal estimated the cointergration properties using Johansen & Juselius model. The study also applied the VAR model to estimate IRF and Variance decomposition. Finally, the study investigated the causal relationship of the two deficits in the framework of Toda- Yamamoto's Granger causality test for causality. From the analysis, the study concluded that the twin deficit hypothesis does exist in Kenya when interest rates and exchange rates are included. In effect, the study proposes that the government should formulate adequate fiscal and monetary policies that will effectively manage the country expenditure and revenue. The government should look into ways of increasing its revenues and reducing expenditures.