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Fiscal Policy and the Current Account S. M. Ali Abbas, Jacques Bouhga-Hagbe, Antonio Fatás, Paolo Mauro, and Ricardo C. Velloso1 May 2011 Abstract This paper examines the relationship between fiscal policy and the current account, drawing on a larger sample of advanced and emerging economies than in previous studies and using a variety of statistical methods: panel regressions, an analysis of large fiscal and external adjustments, and vector auto-regressions. On average, a strengthening in the fiscal balance by 1 percentage point of GDP is associated with a current account improvement of 0.3-0.4 percentage point of GDP. This association appears stronger in emerging and low-income countries, when the exchange rate is flexible, when the economies are more open, when output is above potential or initial debt levels are above 90 percent of GDP, and when using methods robust to endogeneity issues. JEL Classification Numbers: E60, E61, E62, E65, C40, C01 Keywords: fiscal policy, external imbalances, current account, exchange rate Authors’ e-mail addresses: sabbas@, jbouhgahagbe@, antonio.fatas@, pmauro@, rvelloso@ 1 The authors are grateful to Carlo Cottarelli for suggesting the topic and constructive comments, to Philip Gerson and participants in the workshop on External Imbalances and Public Finances at the European Commission, November 2009 for helpful comments, and Junhyung Park for outstanding research support. Abbas, Bouhga-Hagbe, Mauro, and Velloso are in the IMF’s Fiscal Affairs Department. Fatás is Professor of Economics at INSEAD. 2 I. INTRODUCTION The relationship between fiscal policy and the current acco