Fiscal policy, monetary regimes and current account dynamics

The serious current account imbalances which have developed within the euro area over the last decade are at the core of the current financial crisis. For the members of the currency union fiscal policy has gained in importance due to the loss of monetary policy as an autonomous policy instrument. Based on a small open economy DSGE model with fiscal feedback rules, we analyze dynamic macroeconomic responses in particular of the current account to different shocks under alternative exchange rate regimes. Our results indicate that entry into monetary union and the subsequent loss of national monetary policy make the economy more vulnerable to a productivity shock and leads to higher variability of the real exchange rate and the current account. On the contrary, for a risk premium shock, an entry into EMU implies lower variability of most macroeconomic variables, but a higher persistence in the adjustment process of the current account. For both shocks, a countercyclical fiscal response to the current account stabilizes most macroeconomic variables better than a conventional countercyclical response to output, independently of the underlying exchange rate regime. Stabilizing the current account via fiscal policy intervention comes at the price of higher variability of output in the short-run, however. -- Current Account Dynamics ; Fiscal Policy ; Monetary Policy ; Euro Area