Abstract:
This paper explores the empirical relationship between budget and current account deficits in the
case of a small developing country, Sri Lanka for the period of 1960-2010. The data are collected
from annual reports, Centra! Bank, Sri Lanka. The econometric methods used in this study are cointegration
technique, Error correction modeling and Granger causality analysis. The empirical
results are consistent with conventional view. Our empirical results clearly suggest that there exist
statistically significant long-run positive relationship between the trade deficit and the budget
deficit in Sri Lanka. The Granger causality test shows that the direction of causality runs from the
budget deficit to the trade deficit and the relationship is positive and statistically significant.
'••The empirical analysis in this study partially supports the Keynesian view that there is a
linkage between the trade deficit and the budget deficit and the direction of causality is correct
but the Ricardian equivalence hypothesis is not valid for Sri Lankan economy during the study
period.
