Fiscal policy, monetary regimes, and current account dynamics

The matter of increasing current account imbalances within the euro area became more and more apparent in the last years. That progress manifests, for example, in the European commission’s act to enforce the adjustment process of excessive macroeconomic imbalances in the euro area. While the current account is nearly balanced for the euro area in aggregate, growing and persistent dispersions have developed among EMU countries since the establishment of the monetary union in 1999, particularly for some southern European countries like Greece, Italy, Portugal or Spain. In the context of the European Monetary Union, national fiscal policy plays a decisive role in stabilizing country-specific shocks due to the loss of an autonomous monetary policy. The possible link between increase (decrease) in government spending and deterioration (improvement) of the current account has been examined a lot by empirical investigations (see e.g. Ali Abbas et al., 2010).Therefore, for countries with large current account imbalances, a relevant question is to what extent fiscal adjustment can contribute to restore external imbalances.

The paper examines the stabilizing properties of fiscal policy for current account imbalances under alternative exchange rate regimes, i.e. between being member or not of the European Monetary Union. Using a small open economy DSGE model, we analyze how fiscal policy as a stabilization tool affects the adjustment mechanism of productivity and risk premium shocks to the current account and other macroeconomic variables of a small open economy. Our results imply that a fiscal response to current account imbalances improves the stabilizing effect of most macroeconomic variables compared to the standard countercyclical response to output. The entrance into a monetary union and the abolition of a monetary authority leads to higher variability and more persistence of most macroeconomic variables. However, in both monetary scenarios, stabilizing properties of fiscal policy are more effective than without any fiscal response. But, the stabilizing effects of the current account are accompanied by a higher deviation of output in the short-run. Hence, fiscal policy faces a trade-off between stabilizing external positions and output variability.