An Empirical Analysis of the Effect of Budget Deficits on the Current Account Deficits in Kenya

Abstract

There are three main theories that try to explain the association between budget deficits and current account deficits. The Ricardian Equivalence hypothesis suggests that there is no relationship between budget deficits and current account deficits, while the Keynesian expenditure and the Mundell Femming Frameworks suggest that budget deficits affect current account deficits directly and indirectly (through the exchange rate and interest rates) respectively. This study examined the effect of the budget deficit on current account deficit in Kenya using time series data covering the period 1980-2015. To examine the long-run relationship, a cointegration test was carried out and the variables were found to have a long run relationship. To address the central objective, an ARDL model analysis was run in which budget deficit was found to positively influence the current account deficit, while the Real Exchange rate was found to be negatively related to current account deficit and both had a significant effect. In the short run, both factors were negatively related to the current account deficit. The study recommended on appropriate fiscal policies of having restrained budgets and appropriate exchange rate to control the current account policy. Finally, the study proposed further research on the role of the institution and political environment on the current account deficit.