Asian Research Journal of Current Science

In a closed economy with a low degree of capital mobility, all domestic savings are used to finance domestic investment (S = I), meaning that domestic savings and investment should be perfectly correlated. However, in an open economy characterized by high capital mobility, domestic savings are expected to finance investments offering the highest returns, regardless of their geographic location. The twin deficits hypothesis refers to the positive and significant long-run relationship between the current account deficit (X-M) and the budget deficit (G-T). This hypothesis can also be linked to the degree of capital mobility and the Feldstein-Horioka (FH) Puzzle. In cases where domestic savings and investments are not closely related (due to free capital mobility), the budget deficit and the current account deficit may move together. The Gambian economy is in conformity with the FH hypothesis in both the short run and the long run. This paper provides evidence on the validity of the twin deficits and the Feldstein-Horioka puzzle for The Gambia using time series data for the period 1980 to 2023 using the Johanssen testing approach to long-run analysis, Vector Error Correction approach for short-run analysis and Granger Causality. The objective of the paper is to explain the twin deficit hypothesis and the Feldstein-Horioka puzzle in the Gambia. Using the aforementioned VAR tools, the existence of a significant causal relationship between budget deficit and current account balance in both the short run and long run was discovered. The Granger causality result revealed a unidirectional relationship that runs from Gross Capital formation to current Account Balance.  Specifically, the unidirectional relationship runs from GCF to CAB at a 5% significance level. Moreover, the order of integration of each variable was determined using the Augmented Dickey-Fuller test. FD was not stationary at level but was stationary at the first difference at 5% level. The rest of the variables under study have zero order of integration, which means they are stationary at levels. The study recommended that the Government of the Gambia devote attention to capital formation to achieve a budget balance or surplus in the country instead of a budget deficit.