Abstract
A contractionary fiscal policy is the usual policy advice given to countries that experience deficits in current account. However, under certain circumstances, fiscal austerity may worsen external disequilibrium. This paper discusses the conditions in which instability may emerge using a Keynesian model which highlights the crucial role of public investment for structural change and competitiveness in developing economies. In addition, the paper addresses the interactions between fiscal policy, the exchange rate policy and industrial policy. It is argued that a virtuous circle between these variables is possible. A competitive real exchange rate combined with an industrial policy aimed at increasing the diversification and technological intensity of exports may make compatible growth and income distribution.
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