The Effect of Fiscal Deficit on the External Imbalances in the European Union

Abstract

This paper analyzes the effect of the fiscal deficit on the current account deficit in the European Union during the period 1995-2018. The purpose is to examine to what extent an increase in government spending affects the deterioration of terms of trade and contributes to increasing external imbalances. Econometric methods for heterogeneous panel data models are used to analyse the existence of a long-run relationship between the fiscal deficit and the current account. The empirical findings indicate that the twin deficits hypothesis is not confirmed for the whole European Union, but only for a certain number of member states, where a long-run relationship still exists, confirming the impact of the fiscal deficit on the current account. 

Key words: Fiscal deficit, Current account, Twin deficit hypothesis, Panel unit root tests, Panel cointegration analysis, Panel cointegration analysis, Heterogeneous panel data models with cross-sectional dependence.  

JEL: C01, C52, E62, F40.