There has been a plethora of studies concerning the relationship between budget deficit and trade deficit. The overall findings can be classified under two broad hypotheses. One is known as the ‘twin deficit hypothesis’, which implies that there does exist a relationship between budget deficit and trade deficit and budget deficit Granger causes trade deficit. On the other hand, there is an alternative hypothesis known as ‘Ricardian equivalence theorem’, which negates any such relation. This study seeks to test these hypotheses and examine the nature as well as the direction of causal relation between budget deficit and trade deficit in the economy of Maldives, by using real budget deficit and trade deficit data series. This study is based on a battery of tests, such as ADF and PP unit root tests and correlogram, followed by the estimation of cointegration, VECM, Granger causality through VAR model and spectral analysis. The findings of the study support the Ricardian equivalence hypothesis for the economy of Maldives over the period of the study.

The most important event in the history of international economics during the 1970s, was the breakdown of ‘fixed exchange rate’ system and the adoption of ‘flexible exchange rate’ system instead. It was significant because it spelled the end of the spirit of ‘Bretton Woods System’ as incorporated in the IMF Chapter. With the adoption of flexible exchange rate system since the 1970s, another important event emerged, known as the ‘twin deficits phenomenon’ in economic literature.

The phenomenon of ‘twin deficits’ is a recent development in macroeconomic structure of trading economies. Its origin dates back to the 1980s when flexible exchange rate virtually replaced the system of fixed exchange rate. The simultaneous upsurge of the budget deficit and trade (current account) deficit in a relatively large number of countries was observed in the 1980s. The close correlation observed between these two deficits is usually known as twin deficits.

Applied Economics Journal, Time Domain Analysis, Twin Deficit Hypothesis, Ricardian Equivalence Theorem, VAR Model, Budget Deficit, Twin Deficit Hypothesis, Augmented Dickey-Fuller, ADF, Phillips-Perron Tests, Engle-Granger Test, Vector Error Correction Model, VECM, Granger Causality.