Effects of Budget and External Deficits on Economic Growth Evidence From Kenya

Abstract

This Thesis examines the effects of budget and external deficits on economic growth. It reviews whether the long-run relationship between budget and external deficits follows the tenets of: twindeficit hypothesis, the Ricardian equivalence hypothesis, the current account targeting hypothesis, or the feedback linkages. These have in recent years been debated both in developed and developing countries. In contributing to this ongoing debate, the study analyzes the case of Kenya for the period 1980 to 2016. The core objectives of the study are to determine the effect of primary budget deficit on economic growth, examine the effect of current account deficit on economic growth, and to analyze the effects of fiscal and external deficits on economic growth, in Kenya. These main objectives are addressed in the three papers of this study. The study applies relatively novel estimation techniques, namely: Unit Root tests, Johansen Cointegration Analysis with allowance for structural breaks, a dynamic vector error correction Model, and a multivariate Toda and Yamamoto (1995) causality representation. It determines the causal effects of budget and external deficits on economic growth using other alternative measures of budget deficits, external deficits and economic growth. Besides establishing stable and robust causal relationships, this thesis also derives policy suggestions on the signs of the dynamic dependencies examined. The findings reveal that the primary budget deficit has a strong and significant causal effect on economic growth. The estimates suggest a unidirectional causality running from primary budget deficit to growth of GDP per capita. In the short-run, the primary budget deficit reveals a positive relationship but a negative causal effect on growth of GDP per capita in the long run. In the second paper, the estimates suggest that the current account deficit has a significant positive causal effect on growth of GDP per capita in the long run. The estimates further reveal a bidirectional causality running from growth of GDP per capita to current account deficit, and vice versa. In the third paper, results reveal that trade deficit has significant negative causal effect on growth of real GDP with a bidirectional causal effect running from growth of real GDP to trade deficits and vice-versa. These estimates also reveal a unidirectional causal effect running from fiscal deficits to external deficits, providing evidence in support of the twin-deficits hypothesis for Kenya. Overall, the findings provide clear evidence for Kenya and further reinforce the thesis in this study that curbing high budget deficits is crucial for external stability and long-term economic growth in Kenya. xix The main contribution is to provide evidence from Kenya on the dynamic interdependencies between budget deficits and economic growth, external deficits and economic growth, and between budget and external deficits. The evidence is intended to provide useful fiscal, monetary, exchange rate and balance of payments policy insights that can be employed to re-orient policy adjustment measures for macroeconomic stability, price stability, low levels of unemployment and sustained economic growth in Kenya. The novelties of this thesis include: the application of both the trade and current account deficits in macroeconomic policy analysis that highlight whether the presence of direct transfers of capital and investment incomes influence the examined relationships; the application of relatively novel estimation techniques that include cointegration with allowance for structural break and a deeper analysis that appreciates the study objectives more exhaustively in terms of country specific time series variations; the established stable and robust causal relationships that validate the estimates, the application of the transmission mechanisms of budget and external deficits that minimize their adverse economic effects; and finally the application of primary budget deficit that deepens the originality of the research besides offering an opportunity to provide evidence of the interdependencies of discretionary fiscal policy and economic growth for shared prosperity, in Kenya.