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Potential Output Pessimism and Austerity in the European Union

Author

Listed:
  • Pei Kuang

    (University of Birmingham)

  • Kaushik Mitra

    (University of Birmingham)

Abstract

The paper develops a business cycle model with policymakers' learning about potential output to analyze the implications of mis-measuring cyclically-adjusted budget balance (CAB) for fiscal response and the macroeconomy in the European recession after the global financial crisis. The initial recession led to over-pessimism of potential output and structural balance triggering fiscal austerity. The austerity caused further recession, which reinforced potential output and CAB pessimism, requiring continued austerity. Mutual reinforcement between pessimism and austerity contributed to the prolonged recession. The model replicates new evidence on revisions to potential output estimates and the relation between fiscal consolidation and policymakers' beliefs.

Suggested Citation

  • Pei Kuang & Kaushik Mitra, 2022. "Potential Output Pessimism and Austerity in the European Union," Discussion Papers 22-08, Department of Economics, University of Birmingham.
    • Handle: RePEc:bir:birmec:22-08
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    References listed on IDEAS

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    More about this item

    Keywords

    Structural fiscal balance; learning; debt brake; pessimism; potential output;
    All these keywords.

    JEL classification:

    • E62 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - Fiscal Policy; Modern Monetary Theory
    • D84 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Expectations; Speculations

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