Fiscal policy, the terms of trade, and the external balance

Abstract

The effects of fiscal policies on the terms of trade and the external balance are analysed. The external balance is decomposed into changes in the ownership of world wealth across residents of each country, and changes in the distribution of world wealth represented by assets located in each country. It is shown that a rise of government expenditure on the foreign good deteriorates the home country's terms of trade but improves its net foreign asset position. Whether a reduction in equity taxes improves or deteriorates the external balance depends upon the magnitude of a fiscal transmission effect.