Dynamics of Twin Deficits: An Enquiry of the Mundell–Fleming Proposition for India

Published date01 August 2023
AuthorManisha Devi,Amiya Sarma
Date01 August 2023
Subject MatterArticles
Dynamics of Twin
Deficits: An Enquiry of
the Mundell–Fleming
Proposition for India
Manisha Devi1 and Amiya Sarma1
Twin deficits have appeared as the indispensible reality of the Indian economy
since long. The study is an attempt to trace out the inherent dynamics of India’s
twin deficits problem, particularly to unveil its transmission mechanism. Applying
annual secondary data for the period 1971 to 2019, the endeavour reveals India’s
twin deficits encounter to follow the path prescribed by the Mundell- Fleming
open economy IS-LM model. However, India’s realization is found to differ slightly
from the standard theoretical manifestation. In India, domestic exchange rate is
found to appreciate followed by the expansionary fiscal policies of the govern-
ment. The improved exchange rate, owing to the sterilization policies of the
monetary authority to uphold the country’s trade competitiveness, is observed
to augment India’s domestic interest rate. Again, the increased interest rate,
due to its positive effect on the financial inflows, is found to deteriorate India’s
external balance.
JEL Codes: H6, F32, F31, F21, E43
Fiscal deficit, current account deficit, Exchange rate, capital mobility and Interest
Twin deficits are one of the highly pronounced open-economy macroeconomic
phenomena during the last four to five decades in the empirical macroeconomic
literature. In the rhetoric of twin deficits, the terminology twin represents the fiscal
Foreign Trade Review
58(3) 363–385, 2023
© 2022 Indian Institute of
Foreign Trade
Article reuse guidelines:
DOI: 10.1177/00157325221119618
1 Department of Economics, Gauhati University, Guwahati, Assam, India.
Corresponding author:
Manisha Devi, Department of Economics, Gauhati University, Guwahati, Assam, India.
E-mail: devimanisha935@gmail.com
364 Foreign Trade Review 58(3)
deficit and the current account deficit. In a nutshell, the twin deficits hypothesis nar-
rates the causal relationship between the fiscal and the current account deficit in an
open-economy environment. According to the premise, a deficit evolved in the fis-
cal account of a country results in a deterioration of its current account balance. That
is, if there is a deficit in the fiscal account, then it will eventually lead the country to
have a deficit in its current account as well. In the forefront that the Indian economy
is registering persistent deficits both in its fiscal and in the current account balance
over the years, it is often argued that the ceaseless fiscal deficits are the antecedent
of India’s persistent scourge in the current account. The central bank of the country
in its annual report for the year 2018 has also expressed their concern regarding
India’s twin deficits problem. With this preface, the undergoing study is an effort to
track the transmission channel of India’s twin deficits experience.
Foundation of Twin Deficits Hypothesis
The affinity between the two financial accounts of a country’s economy could be
manifested from the conventional open-economy national income identity. The
identity expresses current account balance as the sum of fiscal balance and domes-
tic private savings–investment gap. That is:
Current account balance = Fiscal balance + Domestic private
saving–investment gap
The proponents of the twin deficits hypothesis assert that provided the private
saving–investment gap is stable, an increment in the government’s budgetary
deficit would lead to an increase in the trade deficit.
Transmission Mechanism of Twin Deficits: A
Theoretical Exploration
The open-economy macroeconomics literature provides two theories that are found
to furnish some explanation of the causal relationship that starts from the imbal-
ances that appeared in the government budgetary account and culminates in a dete-
riorating impact on the external financial position of a country. Those two approaches
are the Keynesian absorption approach and the Mundell–Fleming open-economy
IS-LM model. Notwithstanding, both propositions belong to the Keynesian school
of thought; however, their projected way of transmission differs. According to the
Keynesian framework, an expansionary fiscal policy would lead to an increase in
disposable income. Aggregate demand being a function of income will accelerate
followed by the changes in income. Again, the extended overall demand will also
increase the demand for imported articles eventually leading up to an imbalance in
the current account of the economy. Thus, under the Keynesian channel, fiscal defi-
cit tends to deteriorate the external balance of a country by influencing its domestic
absorption. In brief, the channel can be placed in chronological order as follows:

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