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Fiscal Deficits, Current Account Dynamics and Monetary Policy

A renewed interest in the dynamics of the current account spurred by productivity and fiscal shocks has recently emerged as a consequence of the record deterioration of the current account balance in the US, which has been accompanied first by the faster productivity growth of the 90's, and then by the new large fiscal deficits run in the aftermath of September 11.

Standard economic theory has a simple textbook argument to explain the negative effect of large fiscal deficits on the current account: an increase in public spending or a reduction in taxes lowers national savings; if investments do not react too much (as supported by most empirical evidence), it is necessary for the trade balance to match the reduction in national savings and for the country to become a net debtor. The effect on the current account will depend upon capital mobility (and substitutability) among foreign and domestic assets, the planning horizon of agents and the degree of financial markets participation.

A powerful tool to integrate such long-run view with fully specified short-run dynamics, maybe provided by open economy Dynamic Stochastic General Equilibrium (DSGE) models. These models are also the natural environment to investigate the dynamic effects and the international transmission of idiosyncratic productivity shocks.

In the New Open Economy Macroeconomics (NOEM) literature, several contributions have been devoted to analyze monetary policy. However, in the same literature the analysis of fiscal behavior has been given less attention, and it has been mainly limited to the analysis of balanced budget (BB) policies. The benchmark open economy model in the NOEM tradition (the Redux model of Obstfeld and Rogoff, JPE 1995) builds on the joint assumption of infinitely lived household and frictionless financial markets.

Hence, this model results in non-stationary net foreign asset dynamics; moreover ricardian equivalence in this setting severely limits the range of fiscal policies that can be studied. On the contrary, the Stability and Growth Pactinthe European Union stimulated an increasing number of empirical studies focusing on discretionary fiscal policy as a stabilization tool. Such studies emphasized the empirical performance of different endogenous fiscal deficit feedback rules.

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Fiscal Deficits, Current Account Dynamics and Monetary Policy