| Abstract : | The variables that we use to explain how current account is affected by fiscal policy are listed below. All the variables that we used are seen through literature as important determinants of current account and are used in most of academic papers that tried to explain the movement of current account. In the present study those variables are used as controls in order to help us understand better the separate effect of fiscal policy on current account. It is important to notice that in literature the effect every variable has on current account is divided in effects that come from behavior of the global markets, governments etc. and in effects that stem from the behavior of individuals. In some cases those effects coincide, but also they may differ. Fiscal Balance Fiscal Balance, as mentioned above, is likely to have a positive impact on the current account balance. That means, according to the twin deficit hypothesis, that a fiscal surplus is going to improve the current account balance and a fiscal deficit will make the current account balance deteriorate . A simple version of the hypothesis notes that the current account balance is equal to saving minus investment, so any expansion of the fiscal deficit, that lowers public saving must lower the current account balance. The more sophisticated version of the hypothesis takes into account the endogeneity of private saving and investment decisions. A fiscal expansion boosts domestic spending, pushing up domestic interest rates relative to foreign rates, this attracts foreign investors and makes the local currency stronger, something that leads to widening the current account deficit. Gruber, Kamin (2006). However, some papers Bussière (2005) show that the twin-deficit hypothesis does not necessarily hold when consumers act in a “Ricardian” manner. If the fiscal situation is perceived by agents as increasingly unsustainable, then tax increases or reduction in government spending (i.e. fiscal consolidation) are expected in the future. which will affect agents’ future net wealth. In this case, a higher fiscal deficit (or lower fiscal surplus) in the present decreases consumption and increases precautionary saving, so that agents maintain their long-run rate of consumption, in an environment of reduced future disposable income. This would lead to a lower current account deficit (or higher current account surplus). Thus, to the extent that private agents do not adjust their saving more than the change in the fiscal balance, we expect the current account to respond positively to the fiscal balance otherwise it is going to respond negatively. Risk Premium -Interest rate (Government Bonds) The typical prediction is for the interest rate and current account to be negatively correlated. That happens because fiscal tightening is likely to make interest rates fall. Smaller interest rates will increase the capital inflows from external borrowing and thus the current account deficit will be widened, Spiro (1997). On the other hand, we have to take into account the effects of possible financial shocks. Those shocks may be noticed by an increase in the risk premium charged on external liabilities. Blanchard et al (2010), develop a model of a small, emerging economy in which these different types of shocks can be analyzed. They show that an increase in the risk premium are associated with a narrowing of the external balance. Similarly, in the IMF’s Global Economic Model, which is a general-equilibrium macroeconomic model of the world economy,an increase in the risk premium on external debt can be shown to deliver a reduction in external imbalances and a decline in output in debtor countries Lane and Milesi-Ferretti (2007). Also some authors suggest that there is a positive correlation between interest rates and the current account balance. The intuition behind that claim is the following. We have to take into account the expectations about growth and default rates in the countries. Countries that are expected to keep their growth level or are perceived as strong, stable countries are anticipated to have lower default probabilities. This anticipation lowers the interest rates in a way that dominates the increase in interest rates that arise because of additional borrowing. Mark Aguiar, Gita Gopinath (2006). Exchange Rate The exchange rate is expected to have an impact on the current account. If there is a depreciation in the exchange rate, then that particular country will experience a fall in the foreign price of its exports. It will appear more competitive and therefore there will be a rise in the quantity of exports. Assuming demand for exports is relatively elastic then a depreciation will lead to an increase in the value of exports and therefore improve the current account deficit. Similarly a depreciation of the exchange rate, will also lead to an increase in the cost of buying imports. This will lead to a fall in demand for imports and also help to reduce the current account deficit. Therefore, in theory, a depreciation in the exchange rate should improve the current account and an appreciation should worsen the current account. Fiscal policy can affect the current account by altering the relative price of non-tradables, that is the real exchange rate, higher government spending on non-tradables (such as the services or real estate sectors) can induce a real appreciation, which in turn can drive private consumption toward, and production away from, tradables. Demographics As we mentioned above the current account is, by definition, identical to the imbalance between national saving and domestic investment. Therefore, a saving–investment imbalance in an individual country determines its current account balance. The literature on the determinants of national saving has pointed to a number of additional ‘structural’ determinants such as demographics. From the perspective of current account determination, however, demographic profiles should be important only insofar as they differ across countries and, thereby, influence cross-country differences in saving Chinn and Prasad (2003). There could also be differences in saving patterns of working-age cohorts depending on the fractions of the dependent population that are comprised of young and old dependents (very young but also old people are not expected to save). In our empirical work, we take into consideration the effects of young and old dependency ratios. According to Kim and Lee (2007) increased dependency ratios are expected to affect negatively both public saving and domestic investment. Financial development Low level of financial development might indicate an inefficient domestic financial system, which might encourage savers to invest abroad, and thereby a low level of financial development might coincide with a current account surplus. However, low level of financial development could also indicate the presence of credit constraints, which lowers private savings and thereby the current account surplus. We have also to take into consideration the fact that the global financial system is becoming more liberalized and integrated, that fact allows larger external imbalances to be financed than in the past because of the ability of the financial system to move capital among countries. Gruber, Kamin (2006) Stage of economic development Relative real GDP per capita represents an important factor in explaining current account developments, linking the intertemporal approach to the current account and the stages of development hypothesis. A small open economy that starts from relatively low domestic income is expected to have low saving, as the optimal consumption levels are high relative to current income. This implies increased external borrowing against future income, which coupled with substantial initial investment needs, would translate into larger current account deficits at an early stage of development. As the economy catches up and a higher level of development is achieved, external financing needs tend to moderate. Thus, we expect relative real GDP per capita to be positively related to private saving and the current account. ECB (2010)
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