The proposed project aims to develop an open economy model using state of the art techniques of dynamic macroeconomics that incorporates informal economy and fiscal policy. This model will be used to analyze the effects of the presence of an informal sector on the external balances of European countries, specifically how it affects the current account balance, productivity, competitiveness and the role of fiscal policy in an open, integrated economy.The questions that this project raises are:1) What is the effect of the size of the informal sector on the competitiveness and current account balance of a country ?2) To what extent it affects the relationship between fiscal policy and current account balance?3) What is the optimal fiscal policy under the presence of an informal sector with a concern of resolving external imbalances?The objective of this project is threefold: First, a comprehensive panel data set will be collected which should at least include current account balance, gross national and domestic products, public and private savings, external debt and its composition, competitiveness measure, terms of trade, age-dependency ratio, informal sector size, government spending and tax revenue. Second, a rigorous empirical analysis will be conducted using the modern econometric tools of time-series analysis and dynamic panel data analysis in order to understand the relationship between informality, competitiveness and current account balances. Third, based on the results of the empirical analysis, a dynamic open economy macroeconomic model will be built which incorporates informal sector and fiscal policy in order to understand the economic mechanism behind the relationship between informality, external balances and fiscal policy which will shed light on the policy recommendations on the design of an optimal fiscal policy under the presence of an informal sector in an open-economy context.