This chapter 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. The extent to which fiscal adjustment can lead to predictable development in the current account remains controversial, with two competing views. The traditional view argues that changes in fiscal policy are associated with changes in the current account through a number of channels that are discussed in the literature review. The traditional view is challenged by the Ricardian equivalence principle, which states that an increase in budget deficit (through reduced taxes) will be offset by increases in private saving, insofar as the private sector fully discounts the future tax liabilities associated with financing the fiscal deficit, hence not affecting the current balance.
This chapter first appeared as IMF Working Paper 12/51 and was later published in the journal Applied Economics, Vol. 45, No. 29, pp. 4137–51. It is reproduced here with minor editorial changes.