How does financial liberalisation affect the influence of monetary policy on the current account

Abstract Does the current account improve or deteriorate following a monetary policy expansion? We examine this issue theoretically and empirically. We show that a standard open economy DSGE model predicts that the current account response to a monetary policy shock depends on the degree of financial regulation. In particular, financial liberalisation makes it more likely that the current account deteriorates following a monetary expansion. We test this theoretical prediction with a varying coefficient Bayesian panel VAR model, where the coefficients are allowed to vary as a function of the degree of financial, product and labour market regulation on data from 1976Q1-2006Q4 for 19 OECD countries. Our empirical results support the theory. We therefore conclude that following a monetary policy expansion, the current account is more likely to go into deficit in countries with more liberalised financial markets.