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TESTING THE TWIN DEFICIT HYPOTHESIS FOR

KENYA 1970-2012

ERASTUS KAIBA NJOROGE

A research project presented to the Department of Applied Economics, in the School of Economics, in partial fulfillment of the requirements for the award of Degree of Master

of Economics (Finance) of Kenyatta University

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DECLARATION:

This project is my original work and has not been presented for a degree in any other University or any other award.

Signature: ' --

Date:'J:;L,}OS}

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14£

Erastus Kaiba Njoroge, BlEd Arts Reg. No.: KI02/CTY/PT/21S0S12010

This project has been submitted for examination with our approvalas University Supervisors

Signature

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Date:.~?

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tJJ.f.[f?

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Name: Dr. George K. Kosimbei

Position: Lecturer, Department of Applied Economics

Signature: _.--."

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,

Name: Dr. Julius Korir

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DEDICATION

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ACKNOWLEDGEMENT

I wish to express my sincere gratitude to my Supervisors. I owe the success and completion of this project to Dr. George Kosimbei and Dr. Julius Korir

Special thanks goes to Dr. George Kosimbei, my supervisor, for his undivided support during the writing of this project and for being more than generous with his expertise and precious time. His patience and understanding, his countless hours of reflecting, reading, encouraging, and most of all patience throughout the entire process went a long way in ensuring I came up with a quality project.

I would like to acknowledge Dr. Julius Korir for guiding me step by step and assisting me to ensure that I finalize with the project in time. His unlimited assistance is the reason I managed to come up with a final copy.

My sincere thanks go to the lecturers in the School of economics, Kenyatta University for their constructive criticism. Their willingness to provide feedback made the completion of this study an enjoyable experience.

Finally, I take this opportunity to thank my wife for reading through the project page by page to ensure errors and omissions are minimized;

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ABSTRACT

Macro-economic theory suggests that there exists a causal relationship running from Budget Deficit to Current account deficit a concept normally referred to as the Twin Deficit Hypothesis (TDH). This claim has more often than not been the subject of debate in the scholarly and policy front. Majority of existing literature

on the twin deficits hypothesis focuses on its relevance in already developed economies. Further, existing literature has concentrated on analyzing the TDH on a bivariate approach using annual data. This study sought to investigate the relevance of the TDH nexus for Kenya using quarterly data in a multivariate approach which included budget deficits, current account balance, interest rates and exchange rates. The study analyzed quarterly data for a four decade period spanning from 1970Ql - 2012Ql. To estimate if a relationship exists between the variables, the proposal estimated the cointergration properties using Johansen &

Juselius model. The study also applied the VAR model to estimate IRF and Variance decomposition. Finally, the study investigated the causal relationship of the two deficits in the framework of Toda- Yamamoto's Granger causality test for causality. From the analysis, the study concluded that the twin deficit hypothesis does exist in Kenya when interest rates and exchange rates are included. In effect,

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Ta

b

le of Contents

DECLARATION: i

DEDICATION ii

ACKNOWLEDGEMENT iii

ABSTRACT IV

TABLE OF CONTENTS v

LIST OF ACRONYMS AND ABBREVIATIONS vii

OPERATIONAL DEFINITION OF TERMS viii

CHAPTER ONE: INTRODUCTION 1

1.1 Background 1

1.2 Overview oftrends inTwin Deficit Hypothesis Variables in Kenya 3

1.3 Statement of the Problem 6

1.4 Research Questions 9

1.5 Objectives ofthe Study 9

1.5.1 General Objective 9

1.5.2 Specific Objectives 9

1.6 Significance of the Study : 10

1.7 Scope of the Study 12

1.8 Organization of the Study 12

CHAPTER TWO: LITERATURE REVIEW 13

2.1 Introduction : 13

2.2 Theoretical Literature 13

2.2.1: Keynesian! Conventional proposition 13

2.2.2: The Mundel Flemming Approach 14

2.3 Empirical Literature in other countries 19

2.5 Overview of Literature 26

CHAPTER THREE :METHODOLOGy 29

3.1 Introduction 29

3.2 Research Design 29

3.3 Theoretical Framework 29

3.4 Model Specification 36

3.5 Definition and Measurement of Variables 37

3.6 Data Collection 38

3.7 Data Analysis 39

CHAPTER FOUR: EMPIRICAL FINDINGS .43

4.1 Introduction 43

4.2 Diagnostics 43

4.2.1 Unit root test ~ 43

4.2.2 Lag Length Selection 45

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4.2 Cointergration Test : : 46

4.3 Test for causality 49

4.4 Impulse Response Functions andVariance Decomposition 51

CHAPTER FIVE: SUMMARY, CONCLUSIONS AND POLICY

IMPLICATIONS 54

5.1 Summary 54

5.2 Conclusion 55

5.3 Policy Implications 55

5.3 Areas F or Further Research 55

REFERENCES 57

APPENDICES

Appendix I: List of Tables 62

Appendix II:List of Figures 63

Appendix III:Results for the Unit Root Tests 64 Appendix IV: Graphical Results for the Impulse Response Function Tests 67 Appendix V: Results forthe Variance Decomposition Tests 68 Appendix VI: Tabular Results for the Impulse Response Function Tests 69 Appendix VII: Summary Effect of Monetary and Fiscal Accommodation under

Fixed Exchange Rates 74

Appendix VII: Summary Impact of Monetary and Fiscal Accommodation under

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TDH VAR KNBS BD CAD GDP CBK IMF OLS VECM ECM IFS

LIST OF ACRONYMS AND ABBREVIATIONS

Twin Deficit Hypothesis Vector Autoregressive

Kenya National Bureau of Statistics Budget Deficit

Current account deficit Gross Domestic Product Central Bank of Kenya International Monetary Fund Ordinary Least Squares

Vector Error Correction Model Error Correction Model

International Financial Statistics

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OPERATIONAL DEFINITION OF TERMS

TERM MEANING

Twin deficit Hypothesis The concept states that there exists a positive relationship between budget and current account deficit, and that the causality runs from budget deficit to Current Account Deficit.

The relationship between cause and effect Causality

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CHAPTER ONE

INTRODUCTION

1

.

1

Background

Mccoskey and Kao (1999) define the Twin Deficit Hypothesis (TDH) as the long

run positive relationship between the budget deficit and the current account

deficit. The TDH nexus postulates that an increase in budget deficits (BD) leads

to an increase in current account deficits (CAD). According to Ahmad, Lau and

Ahmed (2006), the link between the two deficits has been at the core of research

interest since the 'Reagan Fiscal Deficits' in the 1980s, a period that marked

expansive growth in the two deficits especially in the US rousing researchers and

scholars to explore their relationship. Over time research on the relationship

between the two deficits has spread to other developed and developing nations.

The TDH nexus can be explained usmg ,the Keynesian income-expenditure

framework, (Brian, 2011), and the Mundell Flemming framework (Ahmad et al.,

2006). According to the former, an expansionary budget leads to increased

income ultimately resulting in increase in aggregate demand for domestic and

imported goods. The increase' in imports leads to a worsening of the current

account balance. According to Mundell Flemming, an increase in budget deficit

causes an upward rise in interest rates if government borrows domestically to

finance the deficit. This rise in interest rate leads to ,capital inflows and

consequently an appreciation of the exchange rates. This means exports become

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less attractive while imports become attractive ending up worsening the current

account. This approach however depends on the openness of the economy and the

exchange rate regime.

In

a fixed exchange rate regime expansionary fiscal policy

would lead to increased income a process that would still worsen the current

account (Mundel, 1968).

Government spending can be considered as an engine of growth in any country.

As an agent of the people, the government is tasked with the responsibility of

provision of social amenities such as education, health services and infrastructure.

As such, it is very difficult for a government to curtail its expenditure appreciably

at the expense of the aforesaid responsibilities. The dilemma is compounded

further by the fact that due to low levels of income and development mainly in

developing nations, there is a very narrow scope for increasing tax revenues

(Khalid and Guan, 1999). In the process of discharging the enormous

responsibility, expenditure outstrips revenue. The government may resort to

borrowing and the challenge with this option lies in ensuring that the debt is

prudently utilized to meet people's needs, aid, growth as well as ensure that

derived income is sufficient to meet the repayment needs.

Understanding the connection between the two deficits has a number of

advantages. First, large budget deficits caused by either internal or external

borrowing has consequences on future generations who are left with a repayment

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adoption of the budget policy by the National Assembly. Chapter 12 of the

constitution on the other hand outlines principles shall guide aspects of public

finance in the country, revenue sharing and allocation guidelines as well as

appointment of various relevant state officers.

Despite stringent fiscal policies that seek to bring about fiscal discipline in the

country, the problem of expanding budget and current account deficits continue to

face the country. Figure 1.1shows the trends in the country's current account and

budget balances as a percentage of GDP

%ofGDP

4~---,

o

-4 -8 -12

-16

-204-~'-~'-~'-~'-~'-~-'~-'~-'~-''-~'-~'-~'-~'-~

1970 1975 1980 1985 1990 1995 2000 2005 2010

1

--

BD--CAB

1

Source: IMF, World Economic Outlook Database, April20J3

Figure 1.1:Kenya's Current Account and Budget Deficits as a Percentage of

GDP

As shown Figure 1.1,a striking feature of the country's fiscal operations since the

1970's indicate that Kenya has been running budget deficit and current account

deficits for many years since independence. This rise in spending is due largely to

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government initiatives to improve infrastructure and support the country's free

education system for an increasing population as well as due to poor budgetary

planning (Wawire, 2006). Government spending has been on a rapid increase that

has not been matched by a commensurate rise in government revenue. The worst

Budget deficit recorded was in 1992-1994 when donor funding was cut from

Kenya. In efforts to rein in spending, the Kenyan government made policy

changes in 2000 and 2001, including efforts to improve fiscal discipline and

transparency by strengthening the government's Office of the Controller and

Auditor General. In order to increase tax revenue, the Kenyan government has

also expanded its consumption tax policy to apply to more goods. These policy

changes have been successful at managing the recent budget shortfall, but budget

deficits continue to be a problem for Kenya.

The country's current account balance has also remained mostly negative over the

years. The current account deficit rose from 2.9 percent of GDP over 1964-73 to

6.9 percent over .1974-79 on account of the two oil shocks, widening trade

balance and overvalued domestic currency. Long term flows turned from a

position of 5 percent of GDP over 1964-73 to a -l.8 percent of GDP over 1996

-2000 prompting the country to rely increasingly on risky short term flows to

balance the accounts. The situation was aggravated in the late 90's due to afreeze

in donor aid and lending with the country recording lowest budget balance. The

trend has been worsening since 2008 partly due to the aftermath of the disputed

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Figure 1.2 presents movements in volumes of imports and exports forKenya.

40

30

!I ...•

.

.

.

"

.

:

..

--

.

-10

, 0 ~I

'fit r0 "'" lf) CD r-,

.

s

'"" N r0 "" lf) r-. 00

~ 0 en en

~

en en en en ·en

.

0 0 0 0 0 0 0 e-t

en (;, en en en en

i

'

en 01 0 0 0 0 0 0 0 0 0 0

.--j rl rl rl rl rl ,--l rl

N N N r-I N N N N N N

Year -20

Volume of Imports ofgoods % Change ••• Volume ofexports ofgoods %Change

Source: IMF, World Economic Outlook Database, April 2013

Figure 1.2: Percentage Change in Volume of Imports &Exports

As shown Figure 1.2,the country's import bill continues to expand at a rate that is

not commensurate to the expansion of the export bill. It was largely anticipated

that, with the implementation of the EAC Customs Union in 2005, Kenya would

dominate regional trade by diversifying its exports to the EAC market, given its

comparative advantage, especially in the manufacturing sector. However, this has

not been the case and as shown above, imports largely exceed the volume of

exports.

1

.3

Sta

te

ment

o

f the Problem

Kenya has continuously been running budget deficits and current account deficits

with the exception of 1993 and 2002 where a current account surplus of +2% of

GDP was recorded. Stephen (2010) noted that in order to achieve macroeconomic

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stability and sustained economic growth, the two deficits have to be kept in

control. Keeping a balance between the two macro-economic variables is a

problem not only for developed countries but also for most developing countries.

Recurrent budget deficits tend to overburden future generations through principal

and interest repayments especially if the borrowed funds are allocated to recurrent

as opposed to development budgets (Egwaikhide et al., (2002).

Many studies on the twin deficit hypothesis have been carried out but there is

hardly any consensus on the direction of causality between budget ~Qleficitsand

current account deficits. In the case of Kenya, Kosimbei (2002) and Egwaikhide

et al. (2002) have carried out studies and found contradicting results. Kosimbei

(2002) found support for Ricardian equivalence while Egwaikhide et al. (2002)

found support for unilateral causality running from current account deficit to

budget deficits. These contradicting findings raised a need to investigate the

deficits using a different model and different data set.

These studies by Kosimbei (2002) and Egwaikhide et al., (2002), concentrated on

analysis using two variables that is, budget deficit and current account deficit.

However, the transmission mechanism between the two variables may not

necessarily be direct but through effects on variables such as interest rates and

exchange rates. This is because interest rates and exchange rates affects other

important economic variables such as investments and GDP growth. Therefore,

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current account deficit through intermediating variables of interest rates and

exchange rates. No study had earlier included the two variables for a study on the

causality between the budget deficit and current account in Kenya.

Also majority of past studies including the studies for Kenya by Kosimbei (2002)

and Egwaikhide et al., (2002), had concentrated on testing for causality using

Granger causality test which have been blamed for concentrating on time

precedence rather that causality thus being weak in establishing the relation

between forward looking variables (Abdur and George, 2003). Since these

causality tests are grounded on asymptotic theories that are only valid for

stationary variables, non-stationary data has to be differenced until it's stationary.

Various models offer Error correction which are cumbersome and sensitive to the

values of nuisance parameters in finite samples and thus their results are

unreliable, (Toda and Yamamoto 1995) and (Zapata and Rainbaldi 1997). Toda

and Yamamoto (1995) proposed a better procedure that permits casual inference

to be performed in level VARs that may contain integrated process without

involving the rigorous attention and strict reliance upon intergration and

cointergration properties variables in the system. The purpose of this study was to

investigate the relation between budget deficits and current account Deficits

within the context of indirect transmission and testing causality using the recent

Toda Yamamoto methodology.

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1.4

Research Questions

The study sought to answer the following questions

i) What is the relationship between budget deficits, current account balance,

interest rates and exchange rates?

ii) Are interest rates and exchange rates significant as intermediating variables in the transmission mechanism between budget deficit and current account

balance?

iii) What is the impact of shocks on budget deficits, exchange rates, interest rates and current account deficits on each other in Kenya

1.5

Objectives of the Study

1.5.1 General Objective

The general objective of this study was to test for the existence of the Twin deficit

Phenomena in Kenya while including interest rates and exchange rates as

intermediating variables.

1.5.2 Specific Objectives

The specific objectives were to:

i. Investigate the relationship between budget deficits, current account

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ii. Establish the significance of interest rates and exchange rates as

intermediating variables in the transmission mechanism between budget

deficit and current account balance?

iii. Investigate the impact of shocks on Budget Deficits, exchange rates,

interest rates and Current Account deficits on each other in Kenya

1.6

Significance of the Study

The Vision 2030 aims at transforming Kenya into an "industrializing,

middle-income country by the year 2030". One key pillar is to maintain a sustained

economic growth of 10%. The vision acknowledges that a stable macroeconomic

environment is the only way 'in which confidence among investors can be

maintained. With a 10% GDP growth target, managing the deficits is key.

Kenya's worst economic performance in the early 1990's due to donors having

withdrawn their funding led Kenya to having the worst economic performance

since independence, (Kosimbei, 2009). This reliance on donor funding has been

characteristic of Kenya's economy despite the vital lessons learnt during the times

that donor aid had been withdrawn. Wawire, (2006) notes that poor budgetary

process coupled with limited resources is to blame for the budget deficit in Kenya.

The 'Jubilee government' is faced by a myriad of challenges including a largely

expanding budget deficit and current account deficit. To make matters worse, the

government also has an obligation to fulfill various national and international

commitments like increased pay for teacher, Millennium Development goals, and

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war on terrorism among others. This proposed expenditure is expected to push the

Kenyan budget & current account deficits plummeting further. Sustainable

fulfillment of these obligations will require no less than proper management of deficits in order to among others, attract foreign investors and consequently

generate tax revenues.

This study was therefore deemed to be important to scholars as well as policy

makers in Central Bank and Ministry of Finance seeking to identify an appropriate solution to the deficits problem. Identifying the connection between

the two deficits would help to provide an appropriate policy recommendation on the specific deficit to target in order to reduce both deficits. Kenya provided an

.ideal scenario for studying the relationship between fiscal deficit and the current account deficit not only because it's a developing nation but also because it has

been running the two deficits for several decades.

Large and persistent current account deficits are among the most serious problems

of many developing countries since they result in economic crises like currency

crises, the burgeoning external debts and the reduction in international reserves. If it is the case that budget deficits do cause current account deficits, then policy

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1.

7

Scope of the Study

The study used a four decade secondary quarterly data spanning 1970 Q1 to 2012

Q

1. Data for GDP, Exchange rate, Interest rates, Budget and Current account

Deficits were collected from the KNBS, CBK, IMF and World Bank's World

Economic Outlook Database.

1.8

Organization of the Study

The rest of the paper is structured as follows;

Chapter two presents the theoretical and empirical literature. The theoretical

literature begins by explaining the four possible directions of causality for the

budget and current account deficits. The empirical literature highlights a number

of past studies that have investigated the problem of the twin deficit not only in

Kenya but the rest of the world. The chapter ends with an overview of the

literature where a highlight of relevance of the literature as well the knowledge

gap is expounded. Chapter three presents the methodology of the study. The

research design, and theoretical framework is discussed. The chapter explains the

models specification, definition of variables. The chapter finalizes by explaining

the set of econometric tests that will be undertaken. Chapter four presents the

findings and chapter five concludes with policy implications and policy

recommendations.

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CHAPTER TWO

LI

T

ERATURE REVIEW

2.1 Introduction

This section provides a discussion of existing theoretical literature and later

reviews a selection of past literary works in order to appreciate how far we have

come. At the end of this section, a critique of the empirical literature is provided

while identified research gaps that the study sought to address are'pointed out.

2.2 Theoretical Literature

Majority of past literature generally concentrated on two testable hypotheses

namely, the Keynesian! conventional proposition and the Ricardian Equivalence

proposition. However, these are not the only testable approaches by which the

interaction between the two deficits can be. studied. As a matter of fact, this

interaction can be studied through four testable approaches.

2.2.1: Keynesian/ Conventional proposition

The first approach is based on the Keynesian/ Conventional proposition. The

argument postulated by the Keynesian-income spending approach indicates that

open budget policies that occur as a result of a decrease in taxes or an increase in

public expenditures cause an increase in the national income. This increase in the

national income boosts the import sector and this consequently results in the

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Considering the aforesaid, it would be true to say that there exists a relationship

between the two deficits and that this relationship runs from budget deficits to

current account deficit. Researchers like Perera and Liyanage (2010) have found

this true and in fact found support for the role of intermediating variables like

exchange rate and interest rates asexplained in the Mundell Flemming approach.

2.2.2: The Mundel Flemming Approach

As postulated by Mundel-Fleming model, a cut in public expenditures in a small

economy with a flexible exchange rate regime would lead to a reduction in

aggregate domestic demand and consequently a fall in GDP. This causes a

reduction in the transactional demand for money pilling a downward pressure on

domestic interest rates which causes a gap between international and domestic

interest rates. The difference in domestic and international interest rates causes

capital outflows and an increase in the demand far investment goods.

Depreciation of the domestic currency due to higher domestic demand and lower

interest rates brings about correction in both the trade balance (a proxy for the

current account balance) and the rest of the macro-economy, including the budget

balance, until the alignment of domestic with international interest rates is

restored.

2.2.3: Ricardian Equivalence Hypothesis

The second- and largely controversial approach- based on the Ricardian

Equivalence Hypothesis postulated by Ricardo states that there exists no

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relationship between the two deficits. The approach explains that an

inter-temporal shift between taxes and budget deficit do not matter for real interest

rates, investment or current account balance. Ricardian equivalence hypothesis

makes a strong presumption people that understand that any increase in

government expenditure that is financed by increased budget deficit will

ultimately be compensated by taxation in the future. Critics of the Ricardian

equivalence hypothesis have objected the five major assumptions which are; i)

Capital markets are perfect, ii) People do not live forever and as such, they do not

care about future taxes, iii) Economic agents and mainly consumers are rational

and farsighted meaning that they satisfy the infinite horizon condition, iv) Taxes

are not distortionary lump-sum per capita and iii) Full employment exists (See

Barro, (1989) for more explanation). Despite the presumptions, some researchers

have found evidence to support this view (See for instance, Kosimbei, 2002;

Ratha, 2009; Brian, 2011).

The two are not the only testable approaches as far as the interaction between

budget and current account deficit are concerned. The third approach- known as

current account targeting- is based on a unidirectional causality that runs from

current account deficit to Budget deficit. Such situation may happen when

worsening of the current account leads to slowing of the economic growth thus

leading to budget deficit. Egwaikhide et al., (2006) notes that this argument is

particularly more likely for countries that highly depend on foreign direct

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importance this approach in analyzing the TDH for Kenya. Scholars like

Egwakhide, et al.(2002; Lau (2006) and Halil (2012) have found support for this

approach.

The final approach is based on a bi -directional causality that runs from Budget

deficit to Current account deficit and vice-versa. Existence of a feedback causality

may cause the causality to run in both directions. Jayaraman and Lau (2008)

-having found supporting evidence for this proposition for 6 Pacific Island

Countries indicate that Bi directional causality is not an unusual phenomenon for

a country that relies on export revenues. This therefore makes this approach

, important for the Kenya situation. Since Kenya operates in a flexible exchange

rate (Ndungu & Ngugi, 1999), the theoretical literature specified on the impact of

fiscal policy in a floating exchange rate regime. Stephen, Benjamin, Francis,

Njuguna and Ngugi (2010) observed that Kenya's capital mobility "is substantial

but far from perfect". For this reason, the theoretical literature was restricted to

the impact of a fiscal accommodation in the case of flexible exchange with low &

relatively high capital mobility.

An expansionary fiscal accommodation raises income causmg an mcrease m

demand shifting the IS curve to the right leading to an increase in interest rates as

shown in Figure 2.1.

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v

Figure 2.1: Fiscal Policy under Flexible Exchange Rates and Low Capital

Mobility

The rise in income causes an increase in the demand for imports & the current

account deteriorates. An expansionary fiscal accommodation causes the IS Curve

to shift from IS to IS1. A new equilibrium at B represents a deficit in BOP since it

is below the original BOP curve. This increase in income raises the transactions

demand for money, driving up the interest rate & causing higher imports. The

resultant capital inflow is however not sufficient to finance the deficit. As such,

domestic currency depreciates shifting the BP to the right &further causes the IS1

to shift out further to IS2•A new equilibrium is reached where IS-LM-BP intersect

at C. Note that the LM curve stays put while the IS curve shifts to the right twice.

The first shift is due to the expansionary fiscal policy, and the second shift is due

to the improvement in the trade deficit brought about by the depreciation.

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If capital flows are more elastic to domestic interest rate movements, the capital

movement's resultant from a fiscal accommodation could be huge. Figure 2.2

shows Fiscal Policy under Flexible Exchange Rates and High Capital Mobility

LM

-, -,

, ,

, . BP

"B

-,

'.

--~

_-~-

y

-

\

P

-

,

.

IS

v

-

Output

Figure 2.2: Fiscal Policy under Flexible Exchange Rates and High Capital

Mobility

An expansionary fiscal policy accommodation shifts the IScurve to IS' and the

economy moves from old equilibrium A to a new equilibrium B. Now, point B is

above the BP line and corresponds to a Balance of payment surplus - at B, the

capital inflows induced by the increase in the interest rate more than compensate

the deterioration in the balance of trade. The external balance is in disequilibrium

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causing an appreciation that shifts the BP curve to the left. The appreciation of the

domestic currency has negative effects on trade: the IS shifts back wiping away

part of the fiscal expansion. A new IS-LM-BP equilibrium is reached in C. The,

IS also shifts twice, but in opposite direction. Higher degree of capital mobility

has undesirable effects on the effectiveness of fiscal policy accommodation with

flexible exchange rates. As noted, the resultant appreciation of domestic currency

has a negative impact on the current account leading to a reduction in output.

Although the expansion is not as large as with low capital mobility, some

expansion still takes place.

2.3 Empirical Literature in other countries

Lau and Baharumshah (2004) used annual data for 1976- 2000 to investigate the

causal link between the two deficits for Malaysia. By employing the Toda

Yamamoto granger causality test, the authors found support for bi-directional

causality. They conclude that the scenario is not an unusual phenomenon for an

emerging country and that any decision to reduce the current account deficit

problem cannot be achieved by taking a fiscal stance only but also use of

monetary policies.

Lau et al. (2006) examined the TDH link for 4 countries which are India,

Malaysia, Thailand and Philippines. While still making use of the Tod

a-Yamamoto granger causality test, the authors found support for bi-directional

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The study also found strong support for TDH for Thailand while for Indonesia,

reverse causality was confirmed. The study confirms that exchange rate and

interest rates are important channels for causality.

Marinheiro (2006) analyzed data for Egypt for the period 1974 - 1989. Using

VECM model, the author tried to determine whether the budget deficit leads to an

external deficit in Egypt. The findings indicated that there exists a causal

relationship from the current account deficit to the budget deficit. This study will

help us compare the findings with those of Kenya, both countries being

developing nations.

Lau, Mansor and Puah (2007) used quarterly data to examine the TDH nexus in

the Five Asian Countries; Korea, Malaysia, Philippines, Indonesia, Thailand. The

researchers used Johansen and Juselius (1990) cointergration procedure and

VECM for Granger causality. Their study was split into two sub periods of 1976

Q 1 to 1997 Q2 and 1997Q3 to the end for each country's sample. In the pre-crisis

period, the authors found support for the TDH for Malaysia, Philippines, and

Thailand. Results indicate causality runs in the opposite direction Korea and

Indonesia. In the Post Crisis period, their research returned similar results with the

exception of Philippines which had a bi directional causality. The researchers

concluded that while as managing the deficits should be an important national

agenda, TDH is not a universal phenomenon, and rather, it is country specific.

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Comparing this study with that of Lau et, al (2006) one gets the notion that model

specified and data characteristics play an important role in determining the results.

Jayaraman and Lau (2008) studied six Pacific Island Countries (6 PIC's) for

1988-2004 using VECM and fully modified OLS method. The study found a

bi-directional relationship in the short run which they indicate is not an unusual

phenomenon for countries that rely on export revenues. In the long run, the study

could not find any causality.

Sadullah and Deniz (2008) used quarterly data for 1996 Q

1-

2006 Q4 to study six

emerging countries. Using panel cointergration and fully modified OLS Method,

the authors in similarity with Akbostanci and Tunc (2002) found supports the twin

deficit hypothesis for Czech, Brazil, Mexico, Colombia, South Africa and Turkey.

Their study points out on the important role of intermediary variables i.e. interest

rates and exchange rates.

Pahlavani and Saleh (2009), used annual data for Philippines spanning from

1970-2005 to test the the direction of causality between the two deficits. Using MWald

procedure for causality analysis, they confirmed a bi-directional causality. The

study advised that policy measures to reduce the budget deficit could play an

important role in reducing the current account imbalances and vice-versa. The

study is consistent with Lau, Mansor and Puah (2007) for the case of Philiphines.

Ganco (2010) undertook to establish the relationship between the two deficits for

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error correction models found out that Budget deficit has impact of Current

account deficits. The study concluded that TDH is not valid for Bulgaria and that

fiscal policies should not be used as a substitute for monetary policy.

Using VECM, Akbar and Mehrara (2011) examine the relationship between no

n-oil deficits in Iran for the period spanning 1959 to 2007. The study established a

positive long run relationship between the current budget deficit and non-oil

current account deficit & found a bidirectional relationship between the two

deficits. They also found that taxes and government expenditure do affect

economic variables especially current account deficit. They thus recommended

that government should control budget deficit in order to manage current account

deficit.

In an effort to analyze Twin deficit hypothesis and Feldstein-Horioka Hypothesis

(FHH) in Turkey, Halil Sami (2011) analyzed data for 1974 to 2010. The study

used ARDL bound testing approach and found evidence in support of TDH &

FHH.

Oladipo and Akinbobola (2011) examined annual data for Nigeria for the period

between 1970 and 2005. The study included inflation and exchange rate as

intermediating variables. The authors used Johansen maximum likelihood

procedure for long run cointergration and granger causality test. They found a

unidirectional causality running from Budget deficit to inflation. Though the test

is not on the budget deficit versus current account deficit, it pinpoints the

(31)

important role played by intermediating variables like inflation and exchange rate

in the economy. The study concludes that relevant measures to enhance policy

coordination among various arms of the government should be put in place. Also,

monetary policy should be made to complement fiscal policy.

Perera and Liyanage (2011) undertook to investigate the relationship between

Budget deficit and Current Account deficit. Using annual data from 1960 to 2009

and quarterly data from 1990 Q1 to 2009 Q4, the authors used Engel Granger

residual based test for cointergration, Johansen maximum likelihood procedure

for long run cointergration and Granger causality to test for direction of causality

& TDH was confirmed. They conclude that there is a possibility of relying on

curtailing budget deficits in an attempt to trim down current account deficits.

In another study for Nigeria, Oladipo et al. (2012) conducted an empirical

analysis of TDH in Nigeria using pair wise granger causality tests. Their study

used annual data for 1970-2008. They found out that budget deficit and current

account deficit are cointergrated with causality running from running from Budget

deficit to current account deficit. They concluded that it's important to

complement budget cuts with a coherent package focusing on policies for export

promotion, productivity improvement and exchange rate.

In another study aiming to analyze The TDH in Iran, Farzane, (2012) studied

annual data for 1971-2007. The study employed Johansen test for cointergration

(32)

causality runs from budget deficit to current account deficits. The authors

concluded that government should curtail nonproductive expenditure in order to

solve the problem of the current account deficits.

Saeed and Khan (2012) used annual data for 1972-2008 to investigate the

dynamics of the two deficits in Pakistan. Using Johansen maximum likelihood

procedure for long run cointergration and error correction model for granger

causality, the researchers found a long run relationship between the two deficits.

This causality runs from budget deficit to current account deficit thus conclude

that Pakistan is a non Ricardian economy.

Ucal and Mehmet (2012) analyze quarterly data for 1996 Q1- 2011 Q4 to test

whether budget deficit has correlation with current account deficit and to check

direction of correlation for Turkey. Using Johansen Cointergration Analysis and

granger causality tests, they found that current account deficit has significant

negative effect on budget deficits. This study contradicts the findings of Sarni

(2011). Saeed and Khan (2012) explain that most researches have reached

contrasting conclusions due to the pre specifications of the models they use.

Brian (2012) employed the use of VAR model to empirically examine the causal

relationship between BD and CAD for Argentina. Using quarterly data from 1976

Ql-2010 Q3, the study couldn't find causality in any direction. As such, the study

concludes that Argentina is a Ricardian nation. The authors are however quick to

(33)

warn on the imperfect nature of the data used. They also indicated that there is

evidence that a better fitting model can be made

Merza et al. (2012) used Ganger causality test, Johansen cointergration test,

Vector Auto regression and Impulse response functions to study the Twin Deficit

Hypothesis for Kuwait. Results for the data spanning from 1993 Q 1- 2010 Q4 indicates that though budget deficits and current account deficits are cointergrated

in the long run, budget deficits respond negatively to shocks in current account

deficits. The findings that twin deficit hypothesis is not existent for the Kuwaiti

economy is consistent with study by Alaksami (2000) for Saudi Arabia which is a

similar economy i.e, oil rich economy.

2.4 Empirical Literature in Kenya

Egwaikhide et al., (2002) studied a number of African countries using data for

1970-1999. Their study employed the use of OLS to analyze for correlation

between the two deficits. The authors found that there exists a positive

relationship between the two deficits for all nations under study except for

Cameroon, Cote d'Ivoire, Gambia, Guinea-Bisau and Mali. Granger causality test

confirmed twin deficit hypothesis for Benin, Burkina Faso, Ghana, Nigeria and

South Africa and bi-lateral causality for Togo. The study found a unilateral

causality running from current account deficits to budget deficits for the case of

Kenya. Their fmdings were particularly important for us as they helped us to

(34)

Kosimbei (2002) used annual data for 1964 to 2000 to analyze the relationship

between fiscal and current account deficit. The author carried out Granger

causality tests which revealed that there was no causality between fiscal and

current account deficits. The study concludes that the Ricardian equivalence is

valid in the Kenyan case with short-run dynamics being the same as long run

equilibrium relationships. In the same year and in contrast to findings by

Kosimbei (2002), Egwaikhide et al., (2002) found a unilateral causality that runs

from current account deficits to budget deficits for the case of Kenya. This

contradicting finding raised the need to investigate the deficits using a different

model, different data set and a longer period data.

2.5 Overview of Literature

It was noted that the past studies suffered from various shortcomings. The first

shortcoming involved the use of cross-sectional data which may not address

country specific issues (See for example Lau, Mansor and Puah (2007) who

examined TDH for Five Asean Countries, Jayaraman and Lau (2008) who studied

six Pacific Island Countries & Festus et al (2002) who studied a collection of

African countries including Kenya).

Secondly, the studies had a shortcoming of having used bivariate causality test

that may likely result in omission of important variables and hence give biased

results. In fact, many studies ignored the role of exchange rates and interest rates

in their studies. The fact that the discussion on the role of interest rates and

(35)

exchange rates and their impact on vanous economic variables has been

controversial warranted their inclusion in the research. No past study regarding

the causality between the budget deficit and current account nexus in Kenya had

included the two mediating variables. The study also took into consideration the

fact that a good econometric model ought to include all relevant variables since

omitting a relevant variable in a model specification would lead to biased results.

Thirdly, unlike past literature which suffered from the use of annual data, the

study used quarterly data to help capture the dynamics that could be omitted

erroneously by use annual data.

Lastly, the study noted that past literature has concentrated on testing for causality

using Granger causality tests which can be modeled by a straight forward

regression (Utku, 1995). Econometric tests have shown that such tests tend to

concentrate on time precedence rather that causality. They are thus weak in

establishing the relation between forward looking variables (Abdur and George,

2003). Also, since the tests are grounded on asymptotic theories that are only

valid for stationary variables, non-stationary data has to be differenced until it's

stationary. Various models offer Error correction which are cumbersome and

sensitive to the values of nuisance parameters in finite samples and thus their

results are unreliable, (Toda and Yamamoto 1995) and (Zapata and Rambaldi

1997). Toda and Yamamoto (1995) proposed a better procedure that permits

(36)

process without involving the ngorous attention and strict reliance upon

intergration and cointergration properties variables ill the system. The study

utilized this latest causality testing technique.

The latest attempt investigating the twin deficit hypothesis for Kenya was by

Kosimbei (2002) and by Egwaikhide et al., (2002). This study therefore sought to

improve on their studies by including more recent data bringing on board recent

developments on the macroeconomic front. The study therefore sought to build on

existing literature by bridging the four Gaps mentioned herein above.

(37)

CHAPTER THREE

METHODOLOGY

3.1

Introduction

This chapter begins by presenting the theoretical framework for the TDH nexus.

This is followed by the model specification highlighting the justification for the

model used. Later, the chapter presents a number of econometric tests that were

undertaken.

3.2

Research Design

The study used non experimental research design. Specifically, the design used

was non-descriptive time series design. Quarterly time series data for the period

1970 to 2011 were used.

3.3

Theoretical Framework

The theoretical foundations of the connection between the budget and current

account deficits can be traced from both the national income identity as well as

the Mundel Flemming (M-F) framework. Virtually, all analyses of the twin deficit

hypothesis begin with a review ofa basic national accounting identity as

highlighted in equation 3.1.

Y=C + G + I + (X -

ML

(3.1)

Where;

(38)

C- Consumption

I- Investment

G- Government expenditure

ex

-

M)- Net Exports

The current account is given as

CA

=

X- M

+

NtL {3.2)

Where Ntr is net transfer. This component was assumed to be very small or

negligible for case of Kenya.

The national investment equation in an open economy is given as;

S

=

Y- C- G

+

CA {3.3)

National Investment is given as

I=Y-C-G (3.4)

Considering an open economy, the savings equation can be given as

S

=

I

+

CA (3.5)

Equation (3.5) depicts that an open economy can source domestically and

internationally for the funds needed for investment activities, that is, borrowing

can allow domestic investments to exceed domestic savings. Savings can also be

separated into private savings (S'") and government savings (sg)to get

S=Spr

+

sg

:

..(3.6)

Spr= yd - C {3.7)

Private savings is given by the part of disposable income (yd) that is saved after

consumption. The government savings on the other hand is given as government

(39)

revenue in terms of taxes less expenditure in terms of expenditure (G) and

government transfers (Tr) as given in equation (3.8) below.

sg= T- G -Tr _ .__.(3.8)

Rising from the above identities, and having separated private savings from

government savings, equation (3.9) holds.

S=Spr

+

sg= I

+

CA . ._. ...(3.9)

Equation (3.9) provides a possibility for re-writing previous equations to a form

that is useful for analyzing the impact of government savings on an open

economy.

Spr=I

+

CA - sg= I

+

CA - (T- G -TrL . .._. 0.10)

Re-arranging equation (3.10)

CA

=

S'"- 1- (G

+

T, -T) ..(3.11)

Where, the expression (G

+

T, - T) in equation 3.11 represents consolidated

public sector budget deficit. It represents the extent to which the government is

borrowing to finance its expenses.

The equation in 3.11 above can be expressed in a simplified form as,

(X -M) =(S- I)

+

(T

-GL

0.12)

Where (X-M) is the current account balance, -(S-I) is the saving and investment

balance, (T-G) is the budget balance. Considering the assumption that S = I, the

current account imbalance may be attributable to a fiscal imbalance.

Equation 3.12 presents the framework under which changes in the budget deficit

(40)

would result in an increase in the latter if and only if the rise in government deficit

decreases total private saving. For instance, if (S - I) remains the same and tax

revenues (T) are constant, an increase in government spending (G) will positively

affect the current account balance. This way, the government deficits that result

from increased purchases tend to reduce the country's current account surplus,

worsening of the external balance.

Critics dismiss equation (3.12) as a simple identity equation and its estimation as

an irrelevant exercise. Further, others consider its estimation to be misspecified to

the scope that financial variables such as exchange rate and interest rates are

omitted and their role as transmission variables ignored. Proponents of the

Mundel Flemming approach believe that a deterioration of the budget deficit

causes the domestic interest rate to rise which results in net capital inflow leading

to an appreciation of the domestic currency and ultimately worsening of the

current account balance via a decline in net exports (Salvatore (2006),

This study considered that the transmission mechanism is important and should be

explicitly taken into account. The study therefore adopted the Mundel Flemming

approach in the analysis of effects of government policies to budget and current

account balances.

The primary paradigm for analyzing the effect of government policies in the short

run is the Mundel Flemming Model. It is an economic model set forth by Robert

Mundel and Marcus Fleming being an extension of the IS-LM Model. They

(41)

extended the Keynesian closed economy IS/LM model in order to predict the

impacts of monetary and fiscal expansions/ contractions under fixed and floating

exchange rate regimes. The model depicts the short-run association between an

economy's exchange rate, interest rate, and output. In addition to the variables

explained in the Keynesian Income equation above, the Mundell Flemming model

also uses the following variables:

M- Nominal money supply

P- Price level

r- Nominal interest rate

e- Real effective exchange rate

L- Liquidity preference/ real money demand

Y" - foreign income

The Mundell-Fleming model is based onthe following equations;

1)The goods market components (IS equation):

Y=C(Y-T)

+

I(r)

+

G

+

X(Y*, e)- M(Y, eL .... O.13)

Equation 3.13 states that output is the sum of consumption, investment,

government expenditure and net exports.

The model now recognizes that the real exchange rate as the relative price of

(42)

demand is influenced by the real exchange rate, as well as by the interest rate,

income, and fiscal policy. Consumption is a function of disposable income while

investment is a function of interest rates. Exports depend on exchange rate and

foreign income. Imports on the other hand depend on exchange rates and

domestic income. The lower the exchange rate the less expensive domestic goods

are relative to foreign goods and thus the greater net exports are. The higher the

exchange rate the more expensive domestic goods are relative to foreign goods

and thus the smaller net exports are. Since the exchange rate is an endogenous

variable, the real exchange rate now adjusts to achieve goods market equilibrium.

2) The money market components (LM equation):

M/P

=

L(r, Y) {3.14)

This equation defines the money market. It states that the supply of real money

balance (MIP) equals the demand L(r, Y). The demand for real money balances

depends negatively on interest rate and positively on income. Money supply (M)

is an exogenous variable controlled by the Central Bank. A higher interest rate or

a lower income (GDP) level leads to lower money demand. The domestic interest

rate is a function of the world interest rate and country risk. Real effective

exchange rate is used to provide the trade-weighted measure.

3) The balance of payment components:

BoP = CA

+

KA {3 .15)

(43)

Where, BoP is the balance of payments, CA is the current account surplus, and

KA is the capital account surplus.

NX =NX

(e,

Y,

Y*L

{3.16)

Where; NX is net exports, e is the exchange rate, Y is GDP/ Output, and Y" is the

GDP of countries that are foreign trading partners. NX depends negatively on the

exchange rate. Higher domestic income (GDP) leads to more spending on imports

and hence lower net exports; higher foreign income leads to higher spending by

foreigners on the country's exports and thus higher net exports. A higher eleads to

higher net exports.

CA=NX {3.17)

Where, CA is the current account and NX is net exports. That is, the current

account is viewed as consisting solely of imports and exports.

K

.

A=

z (r-r*)

+

k ~ {3.18)

Where r* is the foreign interest rate, k is the exogenous component of financial

capital flows, z is the interest-sensitive component of capital flows, and the

derivative of the function z is the degree of capital mobility (the effect of

differences between domestic and foreign interest rates upon capital flows KA).

Considering the extra variables that come into playas far as the interaction

between the two deficits is concerned, Mundel Flemming provides an explanation

as follows. A cut in public expenditures in a small economy with a flexible

(44)

a) Reduction in aggregate domestic demand and consequently a fall in GDP,

b) Reduction in the transactional demand for money,

c) A downward pressure ondomestic interest rates,

d) Gap between international and domestic interest rates,

e) The difference in domestic and international interest rates causes capital

outflows and increase inthe demand for investment goods,

f) Depreciation of the domestic currency due to higher domestic demand and

lower interest rates,

g) Correction in both the trade balance (a proxy for the current account

balance) and the rest ofthe macro-economy, including the budget balance,

until the alignment ofdomestic with international interest rates is restored.

3

.

4

Model Specification

The study utilized a structural Vector Auto Regressive (VAR) model which

unlike other models doesn't- than necessary- impose restrictions to identify the

system. Sims (1980) described the other models as "incredible." The VAR' s

model is especially important because the variables are treated symmetrically in a

structural sense with each variable having an equation explaining its evolution

based on its own lags and the lags of the other variables in the model. Also, no

priori knowledge about the variables is required. VAR's modeling is also

advocated for because is it atheory-free technique (Sims, 1980). Furthermore; the

model has characteristic of simplicity and accuracy (Gordon, 1985).

VAR model took the form,

(45)

n n n ('" 19)

CAD

="

aCAD .+

"/

3

ED .+""'EXRATE +" mINR +Jl J.

l ~ 1 /-1 ~ J (-J ~ Y' /-k ~ -r I-I 1

;=1 .)=1 k=1 .[=1

Where;

CAD- Current Account Deficit

BD- Budget Deficit

EXRATE- Exchange Rate

INR - Interest Rate

3.5

Definition and Measurement

of Variables

The study utilized time series data spanning from 1960 Q 1 to 2011 Q4 which

included budget deficits, current account deficits, exchange rates and interest

rates.

Table 3.1: Variables definitions, measurements and data sources

S. Variable Definition Measurement Data Source

No

1 Budget Deficit- The difference between Data IFS, Statistical

(ED) national government expressed as a Abstracts, Economic

(46)

revenues and expenditures GDP Surveys

2 Current Account The difference between a Data -IFS, Statistical

Balance- (CAB) country's value of total expressed as a Abstracts, Economic

imports and value of total percent of Surveys

exports GDP

3 Exchange Rate- This is the value of one Quarterly real Central- Bank of

(EXRATE) currency for the purposes of exchange rate Kenya conversion to another between

Kenya and USA

4 Interest Rates- A rate which is charged or The 90 day Central Bank of

(INR) paid for the use of money CBK T-bill Kenya website

and is often expressed as an rate was used

annual percentage of the as a proxy of

principal. interest rates

5 Gross domestic The monetary value of all Quarterly IFS, Statisti cal

Product- (GDP) the fmished goods and value of GDP Abstracts, Economic

services produced within a growth in Surveys

country's borders in a shillings was

specific time period used

normally ayear

3.6

Da

t

a Collection

Quarterly time series data spanning from 1960

Q1

to 2011 Q4 were used. Where

quarterly data were not available, annual data were interpolated using cubic spline

interpolation method available in E-views statistical package. Data for exchange

rates and interest rates were collected from the Central Bank of Kenya. Current

account, GDP and budget deficit data were obtained from the IMF's International

Financial Statistics, statistical abstracts and economic surveys from the Kenya

National Bureau of Statistics.

(47)

3.7

Data Anal

y

si

s

The study pursued a number of empirical tests based on time series econometric

techniques. Diagnostics test such as unit roots were estimated. To establish

relationship between variables, VAR analysis was estimated before undertaking

cointegration analysis. To establish the direction of causality between the two

variables of study, causality analysis was done. The study utilized Toda and

Yamamoto (1995), MW ALD testing procedure to test for the causal inferences of

the variables. Lastly, impulse response analysis was carried.

Additionally, It was noted earlier that majority of past literature on the TDH have

concentrated on granger causality test to test for the causality on the two deficits.

These tests have been blamed for concentrating on time rather than causality itself

(Abdur and George, 2003). In most cases, time series data are non-stationary

which means that parameters estimated from the non-stationary variables do not

follow the standard statistical distributions for testing significance & have to be

differenced. Granger causality is done in

an

environment of Error Correction,

(Granger, 1988). The Error Correction Models (ECM's) like Engel Granger ECM

and the Johansen & Juselius Vector Error Correction Models help omit

misrepresentation and omission of important constraints. The ECM's are sensitive

to the values of nuisance parameters in finite samples making the results are

unreliable, (Toda & Yamamoto, 1995) & involve cumbersome process which

(48)

Toda & Yamamoto (1995) proposed a procedure that allows for causal inferences

to be made at level VARs that may not be stationary without use of the rigorous

pretests and strict reliance upon cointergration and integration properties. They

propose a modified WALD -MW ALD- for testing granger non causality which

impose nonlinear restrictions in the properties ofthe VAR models needless to test

for unit roots and cointergration ranks. Not only is the procedure simple, it has

also been found to be superior to both the LR test, (Moscani & Gianni, 1992) and

the Wald test of Toda & Phillips (1993, 1994), as verified by Zapata & Rambaldi,

(1997).

i) Establish the maximum order of integration (dm(L'()

The Augmented Dicky-Fuller (ADF) test, the Phillips-Peron (PP) test and the

Kwiatkokowski, Phillips, Schmidt & Shin test (KPPS) were used. Both ADF and

PP tests are based on a null hypothesis of a unit root 1(1)while the KPSS test is

based on a null hypothesis of Stationarity 1(0).

ii) Determine the optimal lag length. (k).

The optimal lag length was chosen using information criteria like the Akaike

information Criterion (AIC), the Swartz Bayesian Criterion (SBC) and the Sim's

modified log-likelihood test (LR) test.

iii) Set up a VAR-model in the levels. The VAR model will be of Var(k+

dmax/h order. This is the augmented VAR-model.

(49)

iv) Carry out a Wald test for thefirst k variables only with k degrees of

freedom

A modified WALD (MWALD) tests for restrictions on the parameters of a Var

(k) -where k is the optimal lag length as determined in step 1 above- is done by

using the Toda & Yamamoto Procedure. A four equation VAR model of (k+

dma.ih order was set up using the level values of the data. This was regardless of

the order of integration of the various time series data. This test has been proven

to display asymptotic chi square distribution following the usual degrees of

freedom, (Chang & Hsu, 2009).

To estimate the role of interest rates and exchange rates, the study tested for

impact response functions and variance decomposition.

An impulse response refers to the feedback of any dynamic system in response to

an external change. As such, Impulse response functions (IRF) describe how the

economic variables responds over time to exogenous shocks. The analysis is

commonly used in the empirical literature to discover the dynamic association

amongst various variables within vector-autoregressive (VAR) models.

Response ofYi,lts to one-time impulse in Yjt with all other variables dated tor

(50)

Since our VAR

Model

has four variables, we shall analyze the response of a

shock in any of the variables to the others. We conducted IRF tests in order to

map out the time path of the dependent variables in the model, to shocks from the

other independent variables.

Variance decomposition specifies the amount! proportion of information each

variable contributes to the other variables in the model. As an alternative method

to the IRF, it helps to see the impact of shocks in independent variables to the

dependent variables. While as the IRF is used to evaluate the effects of a shock to

one and thus transmitted to other endogenous variables, it cannot tell us the

magnitude of shocks in the system. The Variance decomposition procedure is

applied to define how much of the forecast error variance for any variable in a

system, is explained by innovations to each explanatory variable, over aseries of

time spans. Commonly own series shocks explain most of the error variance,

though the shock will also impact other variables in the system.

(51)

CHAP

T

ER FOUR

EM

P

I

R

ICAL FINDINGS

4.1 Introduction

This chapter presents results of the study. The diagnostics are presented first

followed by cointegration results, causality, and impulse response. The

diagnostics consisted of econometric tests of unit root and lag length

determination. Co integration used Johansen test while for causality analysis, Toda

Yamamoto technique was used.

The empirical studies by Egwaikhide et al., (2002) and Kosimbei, (2002)

employed VAR model and error correction models. Borrowing from those

studies, this study utilized the VAR model which contains information on the

variables themselves, their interactions and the dynamic short-run and long-run

relationships. However, this study used a different model from those of

Egwaikhide et al., (2002) and Kosimbei, (2002) to test for causality between

budget deficit and current account deficit.

4.2 Diagnostics

4.2.1 Unit root test

The study first investigated the integration properties of the data since most of

economic time series data are non-stationary. Augmented Dicky-Fuller test

(52)

statistics were used. The lag lengths for the ADF equations were chosen by the

Modified Akaike Information Criterion (AlC) and Schwartz Bayesian Criterion

(SBC). The lag lengths for PP and KPPS tests were chosen using Newey-West

Bandwidth and Andrews Bandwidth.

Table 4.2 presents the results of the ADF unit root test. As shown in Table 4.2, the

variables under study were found to be integrated of order one, I (1). (See detailed

unit root test results in Appendix III).

Table 4.2: Augmented Dickey-Fuller results

Test critical values: 5% level

LAG LENGTH

CRITERIA SBC MODIFIED AIC

\

PROBABILITY AT 1ST AT AT 1ST

VARIABLE INCLUDED AT LEVELS DIFFERENCE LEVELS DIFFERENCE

BD Intercept 0.0828 0.0004 0.4267 0.0000

Trend &

Intercept 0.0757 0.0024 0.6391 0.0000

None 0.2524 0.0000 0.3345 0.0000

CAB Intercept 0.0049 0.0005 0.142 0.0005

Trend &

Intercept 0.0250 0.0037 0.3768 0.0037

None 0.0556 0.0000 0.0806 0.0000

EXRATE Intercept 0.918 0.0038 0.9045 0.0337

Trend &

Intercept 0.3763 0.0195 0.3752 0.0265

None 0.932 0.0010 0.9116 0.0124

INRATE Intercept 0.1821 0.0103 0.1821 0.0000

Trend &

Intercept 0.2354 0.0404 0.2354 0.0000

None 0.2749 0.0006 0.2749 0.0000

(53)

The four variables namely, budget deficits, current account balance, interest rates

and exchange rates were found to have a unit root at levels. They were however

found to have no unit root at first difference. Hence the variables became

stationary on the first difference.

4.2.2 Lag Length Selection

The maximum lag length was chosen using Akaike information Criterion (AlC),

the Swartz Bayesian Criterion (SBC) and the Sim's modified log-likelihood test

(LR) test. Table 4.3 illustrates the lag selection results.

Table 4.3: Optimal Lag Length Selection

Hannan

-Modified Final Akaike Schwarz Quinn

LRtest prediction information information information

Lag LogL statistic error criterion criterion criterion

0 -2101.812 NA 3176036. 26.32265 26.39953 26.35387

1 -1068.928 200l.213 9.584755 13.61160 13.99600 13.76769

2 -808.3828 491.7792 0.451018 10.55478 11.24670 10.83575

3 -802.7706 10.31237 0.514048 10.68463 11.68406 11.09047

4 -789.2295 24.20470 0.531040 10.71537 12.02232 11.24608

5 -736.3815 91.82347 0.335999 10.25477 11.86923 10.91035

6 -601.897l 226.9424 0.076729* 8.773714* 10.69570* 9.554165*

7 -597.3614 7.427207* 0.089074 8.917018 11.14652 9.822341

8 -588.5393 14.00502 0.098200 9.006742 11.54376 10.03694

9 -567.4779 32.38193 0.093112 8.943474 11.78801 10.09854

* Indicates lag order selected bythe criterion

Four Information criteria suggested that a maximum lag length of 6 for each

variable. However, additional test was carried to determine the number of lag

Figure

Figure 1.1: Kenya's Current
Figure 1.2: Percentage
Figure 2.1: Fiscal Policy under Flexible Exchange Rates and Low Capital
Figure 2.2: Fiscal Policy under Flexible Exchange
+7

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Analysis of the results obtained is the financial behavior of investors in a pattern of 3 things, first, the target pattern of yields and the risk of the shares they buy, sell and

Detailed hematological examination including bone marrow aspiration should be done in these patients to understand and diagnose this disease early so that