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Current Account, Informal Economy and Fiscal Policy

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The role of government in an open economy

An EU group of researchers used new methods to simulate an open economy, including the role of government. Analysis of 185 countries over 50+ years shows the consequences of large deficits and the relationship between growth and the informal sector's reach.

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The EU-funded CAINF (Current account, informal economy and fiscal policy) project developed an open economy model. This new model incorporates the latest dynamic macroeconomic techniques. It addresses the informal economy plus fiscal policy, while also analysing the effects of the informal sector on external balances of European countries. Specifically, the development is intended to show how the informal sector affects current account balances, productivity and competitiveness. Another consideration will be the role of fiscal policy in an open, integrated economy. The team collected and arranged data and conducted an analysis using dynamic panel data econometrics. Work also involved preparations for building the theoretical model at a later stage. Researchers conducted a review of the literature on current account imbalances and the informal economy. They created a database detailing 185 countries over the years from 1960 to 2013. The resulting data enabled exploration of the relationship between current account imbalances and output volatility. Findings suggest that a larger current account deficit will be associated with higher output volatility, particularly for emerging market economies. Secondly, team members analysed the relationship between current account imbalances and informal economies, using dynamic panel data econometrics. Results indicated that economic growth episodes are coupled with current account deficits, and especially for emerging market economies. Growth was negatively associated with the size of the informal sector, and illustrated a switch from informality to formality. Subsequent project work involved a small open economy model, involving heterogeneous firms. Theoretical findings are consistent with empirical facts. The benchmark model constitutes a stepping stone for a more complete theoretical model. The CAINF project has contributed to a better understanding of the effects of various economic policy options. The work also clarifies the impact of informality on external imbalances.

Keywords

Open economy, informal sector, CAINF, current account, fiscal policy

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