RDP 8813: The Fiscal Deficit and the Current Account: Twins or Distant Relatives? 1. Introduction

Current account imbalances have in recent years become a concern of policy makers and public opinion in a number of countries. While it is possible to argue from a theoretical point of view that this concern is misguided, it appears to be a fact of life that governments are being pressured to “do something” to correct external imbalances. Increasingly the conduct of fiscal policy has become the focus of such pressures. It is often argued that budget imbalances of the public sector are at the root of the current account imbalances. The so-called twin-deficit hypothesis goes so far as to assert that an improvement on the fiscal front will bring about a one-for-one improvement in the current account. Unfortunately, the relationship between the two deficits does not appear to be as close as this hypothesis claims. The experience of countries, including Australia, that have taken measures to achieve budget consolidation suggests a significantly looser connection and one that is not invariant across countries or over time.

The aim of the following analysis is to provide a suitable framework for investigating the determinants of the current account and to use this framework to study the relationship between budget imbalances and current account imbalances.^[1] A major conclusion that will emerge is that reactions of the private sector to government policies may partially, fully, or even more than fully offset the effects on the current account of budget consolidation efforts depending on the way in which fiscal policy is altered to achieve a reduction in the public sector's borrowing requirement. Careful empirical analysis is therefore necessary in order to ascertain the impact of changes in fiscal policy on a country's external position.

Footnote

The analytical framework builds on the model presented in Genberg and Swoboda (1987). [1]