Fiscal policy refers to how a government uses taxation and government spending to influence the economy. This policy changes the current account balance primarily by affecting domestic demand, imports, and exchange rates.

How expansionary fiscal policy (lower taxes or higher spending) works:

• Increased government spending or lower taxes boosts aggregate demand.
• Consumers and the government spend more, which includes purchasing more imported goods and services. As imports rise, the current account worsens.
• If the economy is at full capacity, high spending can lead to higher inflation. This makes domestic products more expensive compared to foreign goods, causing exports to drop and imports to rise.
• Higher government borrowing can lead to higher interest rates, which may attract foreign investment. This causes the national currency to appreciate (gain value), making exports more expensive and imports cheaper, further worsening the current account.

How contractionary fiscal policy (higher taxes or lower spending) works:

• Reducing government spending or raising taxes lowers domestic demand.
• As consumption drops, imports fall, which leads to an improvement in the current account.
• However, this may also slow down economic growth and reduce national income.

Key takeaways:

• The income effect is the main driver: when people have more money to spend, they tend to buy more imports. This relationship is measured by the Marginal Propensity to Import (MPM).
• Fiscal policy is a demand-side tool used to manage trade imbalances.
• The crowding out effect occurs when government borrowing reduces private investment, which can sometimes offset the change in imports.
• The J-curve effect suggests that the current account might get worse briefly after policy changes before it begins to show long-term improvement.