Department of Economics Working Papers,
Vienna University of Economics and Business, Department of Economics

Abstract: This paper investigates the relationship between countries' fiscal balances and current accounts with an emphasis on the role of fiscal rules. The direct effect of fiscal policy on the current account via aggregate (import) demand is potentially amplified by indirect effects, materializing through interest rate effects and inter-generational transfers that reduce savings. On the other hand, the implied positive relation between fiscal and external balances is potentially attenuated by offsetting changes in savings through Ricardian equivalence considerations. We expect this attenuation effect to be stronger in countries with more stringent fiscal rules and test this hypothesis using a panel of 73 countries over the period 1985-2012. As previous studies we find a positive effect of fiscal balances on the current account, supporting the twin deficit hypothesis. However, the effect of fiscal balances on the current account depends on the stringency of fiscal (budget balance or debt) rules in place; it is reduced by one third on average and virtually eliminated for countries with the most stringent fiscal rules.

Keywords: Twin Deficits, Fiscal Policy, Fiscal Rules, Current Account

JEL-codes: E62; F32; F41 July 2015

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