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Fiscal policy and the assessment of output gaps in real time: An exercise in risk management

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  • Larch, Martin
  • Cugnasca, Alessandro
  • Kumps, Diederik
  • Orseau, Eloïse

Abstract

Fiscal policymakers are expected to conduct countercyclical policies to mitigate cyclical fluctuations of output, but the assessment of cyclical conditions in real time is subject to considerable uncertainty. They face two types of risk: (i) launching discretionary measures to support or dampen aggregate demand when no measures are required (type I error), or (ii) not launching any stabilising measures when this is warranted by cyclical conditions (type II error). A rational policymaker could manage these risks by correcting real-time estimates for past errors, notably the apparent tendency to underestimate good times when they occur. In practice, however, fiscal policy has been largely pro-cyclical or a-cyclical at best. Using statistical decision theory, we calculate thresholds for realtime output gap estimates beyond which governments could launch stabilisation measures, so as to reduce the risk of running pro-cyclical policies. We consider different preferences for avoiding type I or type II errors, and for addressing upside and downside growth risks. We show that the tendency to run pro-cyclical fiscal policy and the ensuing deficit bias can reflect two factors: a preference for activism that is, attaching a lower cost to type I errors, combined with an inclination to be gloomy about cyclical conditions.

Suggested Citation

  • Larch, Martin & Cugnasca, Alessandro & Kumps, Diederik & Orseau, Eloïse, 2019. "Fiscal policy and the assessment of output gaps in real time: An exercise in risk management," ZEW Discussion Papers 19-013, ZEW - Leibniz Centre for European Economic Research.
  • Handle: RePEc:zbw:zewdip:19013
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    References listed on IDEAS

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    Cited by:

    1. European Fiscal Board (EFB), 2019. "Assessment of EU fiscal rules with a focus on the six and two-pack legislation," Reports 2019, European Fiscal Board.
    2. Larch, Martin & Orseau, Eloïse & van der Wielen, Wouter, 2021. "Do EU fiscal rules support or hinder counter-cyclical fiscal policy?," Journal of International Money and Finance, Elsevier, vol. 112(C).

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    More about this item

    Keywords

    fiscal stabilisation; pro-cyclical fiscal policy; risk management; real-time output gap estimates;
    All these keywords.

    JEL classification:

    • E62 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - Fiscal Policy
    • E63 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - Comparative or Joint Analysis of Fiscal and Monetary Policy; Stabilization; Treasury Policy
    • H68 - Public Economics - - National Budget, Deficit, and Debt - - - Forecasts of Budgets, Deficits, and Debt

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