The Dynamics of Current Accounnt and Budget Deficits: the cases of Ethiopia

Abstract

Analysts and politicians have shown concern over the state of macroeconomic imbalances. They consider the growing fiscal and current account imbalances have been the cause of macroeconomic imbalances which could affect the long term economic progress of a country. Here, the dynamics, causality and long run relationship between the current account and budget deficits along with other key macroeconomic variables are investigated; in a small open economy, Ethiopia. It adopts a VAR based Granger-causality tests, impulse response functions and variance decompositions analysis using annual data for the period of 1970/71 to 2008/09. It has found evidence that suggests the consequences of a large budget deficit on current account deficit become noticeable only in the short run while the effect of persistent current account deficit on budget deficit is far and wide. It follow that policies aiming at reducing the budget deficit could only solve the current account deficit in the short run whereas reducing current account (trade) deficit sustainably may help reducing the budget deficit and hence restoring macroeconomic balances. Therefore, policy makers should give more emphasis to reduce the external deficit. This requires implementing prudent monetary and fiscal policy. In addition, policies must be put in place to increase the capacity, efficiencies and competitiveness of domestic industries in the export sector as well as policies that aimed at broadening the export base to benefit from trade liberalization policies.