Abstract
The relationship between trade deficit and fiscal deficit has remained an important topic in the last decades. The literature reveals many attempts to investigate the relationship between the two deficits, while terminologies like Keynesian Proposition, Ricardian Equivalence, and Targeting Current Account Deficit are used for the relationship between the two deficits. The literature also highlights the possibility of unidirectional or bidirectional causality between these deficits for different countries and different time spans. These four possibilities have inspired us to investigate these possibilities in the light of many control variables like unemployment, urbanization, money supply, foreign direct investment, and economic development in the case of Pakistan. The findings of the study reveal that fiscal deficit significantly accelerates trade deficit into both long term and short term; hence, it supports the Keynesian Proposition in Pakistan, while a bidirectional causality between fiscal deficit and trade deficit into both long term and short term was also observed. Moreover, the mean and variance of error term were also found to be structurally stable which confirms the absence of structural break for the selected period in Pakistan. In the end, based on these findings, this study has concluded that two possibilities prevail out of four on the relationship between fiscal and trade deficits. The twin deficit is relevant and it does prevail in a transition economy like Pakistan.