Fiscal stance, the current account and the real exchange rate: Some empirical estimates from a time-varying framework

This paper examines the time-varying time series processes of the interaction between government fiscal deficits, the current account balance and the real exchange rate for the U.K. and U.S. economies. This is achieved in a novel way by estimating a time-varying vector autoregression model that allows for time variation in the stochastic variance and autoregressive parameters. This paper finds that, contrary to results reported in the recent literature, government deficit shocks worsen the U.S. current account balance. In contrast, results based on the historical time series for the U.K. show evidence of fiscal deficits having actually improved the current account balance. However, in commonality, the time-varying estimates show that the impact of fiscal deficits on the U.K. and U.S. current account balance has fallen in magnitude over the past 20 years. The time-varying variance decomposition results illustrate that fiscal deficit shocks played a key role in driving U.K. current account and real exchange rate fluctuations throughout the 1980s. In contrast, fiscal deficit shocks have been a small factor in the variation of U.S. current account and exchange rate fluctuations over the past 25 years. The time-varying results in this paper do not support the view that future fiscal deficit reductions alone can eliminate U.K. and U.S. current account imbalances.