Fiscal policy and the current account: are microstates different?

Abstract

This article examines the empirical link between fiscal policy and the current account focusing on microstates defined as countries with a population of less than 2 million between 1970 and 2009. This article employs panel regression and Panel Vector Autoregression (PVAR) on 155 countries of which 42 are microstates. Panel regression results show that a percentage point improvement in the fiscal balance improves the current account balance by 0.4 percentage points of Gross Domestic Product (GDP). The real effective exchange rate has no significant impact on the current account in microstates but the coefficient is significant in the global sample. PVAR results show that an increase in government consumption results in real exchange appreciation, but the effect on the current account after an initial deterioration dies out quicker in microstates than in the global sample. The result implies that fiscal policy has little effect on the current account in microstates beyond its direct impact on imports. Overall, the results suggest that the weak relative price effects make the effect of fiscal adjustment on the current account much more difficult in microstates.

Keywords:

• fiscal policy
• current account
• microstates

JEL Classification::

• F32
• H30
• O23

Notes

¹ IMF (2011) outlines a number of shortcomings of using the cyclically adjusted fiscal balance as a measure of deliberate fiscal policy changes.

² We used a 5-year moving SD and changes in terms of trade but the result remains the same.

³ This procedure is also known as Helmert transformation that is based on Arellano and Bover (1995). The procedure preserves the orthogonality between the transformed variables and the lagged regressors, which can be used as instruments to estimate the coefficients by system GMM.