Chapter 4 of WEO- The Twin Budget and Trade Balances

How do changes in taxes and government spending affect an economy’s external balance? Based on a historical analysis of documented fiscal policy changes and on model simulations, this chapter finds that the current account responds substantially to fiscal policy—a fiscal consolidation of 1 percent of GDP typically improves an economy’s current account balance by over a half percent of GDP. This comes about not only through lower imports due to a decline in domestic demand but also from a rise in exports due to a weakening currency. When the nominal exchange rate is fixed or the scope for monetary stimulus is limited, the current account adjusts by as much, but the adjustment is more painful: economic activity contracts more and the real exchange rate depreciates through domestic wage and price compression. When economies tighten fiscal policies simultaneously, what matters for the current account is how much an economy consolidates relative to others. Looking ahead, the differing magnitudes of fiscal adjustment plans across the world will help lower imbalances within the euro area and reduce emerging Asia’s external surpluses. The relative lack of permanent consolidation measures in the United States suggests that fiscal policy will contribute little to lessening the U.S. external deficit.

We find that fiscal policy has a substantial and long-lasting effect on the current account. A fiscal consolidation of 1 percent of GDP improves the current account by over a half percent of GDP within two years, with the improvement persisting into the medium term. The improvement in the current account comes not only through lower imports due to falling domestic demand, but also from an increase in exports arising from a weaker domestic currency.

See chapter 4