Ricardian Equivalence, Twin Deficits and Feldstein-Horioka Hypotheses: Empirical Analysis form Pakistan

Abstract

The study attempts to investigate relationship between both budget and current account deficits for the Pakistan using annual data from 1976 to 2016. In this regard, three hypotheses, Ricardian Equivalence (RE), Twin Deficits (TD) and the Feldstein-Horioka (F-H) are tested under the framework of Multivariate Cointegration techniques (Johansen, Autoregressive distributed lag) and Error correction modeling. The cointegration results reject the RE hypothesis and support the validity of TD hypothesis for Pakistan. It implies that debt-finance tax cut raised the interest rate which attracted the capital inflow. The findings of error correction model also support the short run linkage between both deficits and confirm that long run relationship exists between them, when interest and exchange rates are included in the model. The results of cointegration test further reveal a positive relationship between the current account deficit and investment in the long run. The long run coefficient of investment indicates the high degree of foreign capital mobility and rejects the Feldstein-Horioka hypothesis. However, positive and less than one value of short-run coefficient of investment provide weak support for the Feldstein-Horioka hypothesis. So, the empirical results suggest that investment (coefficient of foreign capital inflow) has a significantly positive impact on current account deficit only in the long run.