Fiscal Policy, Potential Output and the Shifting Goalposts

50 Pages Posted: 17 Sep 2018 Last revised: 18 Feb 2019

See all articles by Antonio Fatás

Antonio Fatás

INSEAD; Centre for Economic Policy Research (CEPR); ABFER

Date Written: August 2018

Abstract

This paper studies the negative loop created by the interaction between pessimistic estimates of potential output and the effects of fiscal policy during the 2008-2014 period in Europe. The crisis of 2008 created an overly pessimistic view on potential output among policy makers that led to a large adjustment in fiscal policy. Contractionary fiscal policy, via hysteresis effects, caused a reduction in potential output that validated the original pessimistic forecasts and led to a second round of fiscal consolidation. The evidence suggests that this succession of contractionary fiscal policies was likely self-defeating for many European countries as the negative effects on GDP caused more damage to the sustainability of debt than the benefits of the budgetary adjustments. The paper concludes by discussing alternative frameworks for fiscal policy that could potentially avoid this negative loop in future crises.

Keywords: Fiscal policy, hysteresis, Potential Output

JEL Classification: E32, E62

Suggested Citation

Fatas, Antonio, Fiscal Policy, Potential Output and the Shifting Goalposts (August 2018). CEPR Discussion Paper No. DP13149. Available at SSRN: https://ssrn.com/abstract=3244525

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