Every Cloud Has a Silver Lining. The Sovereign Crisis and Italian Potential Output

46 Pages Posted: 19 Aug 2015

Date Written: June 25, 2015

Abstract

This paper evaluates the direct and indirect effects of the sovereign debt crisis on Italy’s potential output. The direct effects are captured by the increase in the interest rate paid by Italian borrowers in the second half of 2011, the indirect effects by the policy responses to the crisis (fiscal consolidation and structural reforms). Using a New Keynesian dynamic general equilibrium model, we compute potential output as the “natural” level of output in the absence of nominal price and wage rigidities. The evaluation posits a no-crisis scenario in line with the pre-2011 potential output projections and government budget rules. We find first that the fiscal and financial shocks that caused the 2011-2013 recession subtracted 1.6 percentage points from potential output growth, while the structural reforms in 2013 have limited the reduction in output capacity to about 1.4 points; second, that the structural reforms have a long-run growth-enhancing impact on potential output of around 3 points from now to 2030; and third, that once budget balance is achieved in the medium term (2019), reductions in either labor or capital income taxes would boost potential output growth by about 0.2 points per year.

Keywords: sovereign risk, fiscal policy, potential output

JEL Classification: C51, E31, E52

Suggested Citation

Gerali, Andrea and Locarno, Alberto and Notarpietro, Alessandro and Pisani, Massimiliano, Every Cloud Has a Silver Lining. The Sovereign Crisis and Italian Potential Output (June 25, 2015). Bank of Italy Temi di Discussione (Working Paper) No. 1010. Available at SSRN: https://ssrn.com/abstract=2645682 or http://dx.doi.org/10.2139/ssrn.2645682

Andrea Gerali (Contact Author)

Bank of Italy ( email )

Via Nazionale 91
Rome, 00184
Italy

Alberto Locarno

Bank of Italy ( email )

Via Nazionale 91
Rome, 00184
Italy

Alessandro Notarpietro

Bank of Italy ( email )

Via Nazionale 91
Rome, 00184
Italy

Massimiliano Pisani

Bank of Italy ( email )

Via Nazionale 91
Rome, 00184
Italy

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