Effects of Budget Deficits on the Balance of Payments and Exchange Rate in Kenya: 1993-2023.
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Date
2025-04
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Kenyatta University
Abstract
The balance of payments determines the extent to which a country depends on the rest of the world. On the other hand, the budget deficit is considered a significant metric for a nation’s financial health. The nation’s balance of payments has primarily been in a deficit, at the same time, the budget deficit continues to widen, which has raised much concern among economists and policy makers. This accentuates the necessity to investigate the relationship between budget deficits and the balance of payments. Furthermore, the study examined the effects of budget deficits on current account deficits because the current account makes up the largest portion of the balance of payment and the country’s current account has primarily been in a deficit. Moreover, the study was extended to capture the effects of budget deficits on the exchange rate since imbalances in the balance of payments influence the exchange rate. Theories on how budget deficits influence the balance of payments, current account and the exchange rate are contradictory, despite attempts made by empirical studies tying budget deficits to the balance of payments, current account deficit and exchange rate, there remains to be controversy in their findings with each contention faced with a counterargument. The study utilized quantitative annual time series data spanning from 1993 to 2023 and the error correction model to establish how budget deficits affect the balance of payments in Kenya. In addition, causality tests were employed to investigate the relationship between the current account deficit, exchange rate and budget deficit. The study revealed that an increase in budget deficit deteriorates the balance of payments. The results also demonstrated bi-directional causality between the budget deficit and the current account deficit. In addition, the findings indicated a unidirectional causal relationship between the budget deficit and the exchange rate. The study concluded that since budget deficits influence the balance of payments, there is need to keep the widening budget deficit in Kenya in check. Further, the study recommended the establishment of a regulatory framework tailored towards budget deficit reduction in an effort to strengthen the balance of payments because persistent deficits in the balance of payments reduce reserves and weaken the value of local currency increasing the nation’s vulnerability to external shocks
Description
A Research Project Submitted to the Department of Economic Theory in the School of Economics in Partial Fulfilment for the Requirements for the Award of the Degree of Master of Economics of Kenyatta University, April 2025
Supervisor;
1.Charles Mugendi