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1. Introduction
The size of government activity in influencing the macroeconomic scenario of an economy has increased considerably over the years, as is clear from the swelling fiscal deficit figures or large public expenditures, reported in annual budget documents. The stated objectives usually suggest that it should boost the investment and capital formation, raise the rate of savings, curtail the unproductive consumption, re-allocate the resources from unproductive uses to most desirable channels and keep a check on sectoral or regional imbalances. The success of these objectives obviously relies on the response of various macro variables at which the fiscal policy shocks are targeted, the nature of economy involved and more particularly the nature of government activity itself. If, for instance, government increases the level of current expenditure, then empirics highlights the case of crowding out of private investment and therefore a lower level of economic growth. Contrary to this, a rise in capital expenditure complements the private investment.
In addition to increased fiscal deficits, economies have also witnessed bulged current account deficits. The persistence of these two deficits is a policy concern as the two are regarded as barometers of the internal and external position of an economy. The large fiscal deficits are viewed to oppress the growth performance of an economy, and large current account deficits hinder the international competitiveness, cause a drain of wealth, a reduction in forex reserves and may even switch on a currency crisis. Researchers have, over the years, tried to see the link, any of the fiscal policy changes (budget deficits) and external balance of a country. The standard Keynesian macroeconomics expects a direct association between the two deficits. Whereas Ricardian equivalence hypothesis of Barro (1976, 1989) postulates neutrality between them, and more recently, Kim and Roubini (2008) support a negative association, “Twin Divergence” hypothesis.
In this study, we try to revisit the relational status between two deficits in case of a growing and dynamically open economy, India. We test the null of Ricardian equivalence against an alternative of twin-deficit hypothesis. India has been witnessing high fiscal deficits coupled with high current account deficits over the years. As can be seen from the Figure 1, almost in every year, there is a deficit either in internal or external balance...