Fiscal Policy and the Assessment of Output Gaps in Real Time: An Exercise in Risk Management

20 Pages Posted: 7 May 2019

See all articles by Martin Larch

Martin Larch

European Fiscal Board

Diederik Kumps

Vrije Universiteit Brussel

Alessandro Cugnasca

European Union - European Commission

Eloise Orseau

European Union - European Commission

Date Written: 2019

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.

Keywords: fiscal stabilisation, pro-cyclical fiscal policy, risk management, real-time output gap estimates

JEL Classification: E62, E63, H68

Suggested Citation

Larch, Martin and Kumps, Diederik and Cugnasca, Alessandro and Orseau, Eloise, Fiscal Policy and the Assessment of Output Gaps in Real Time: An Exercise in Risk Management (2019). ZEW - Centre for European Economic Research Discussion Paper No. 19-013, Available at SSRN: https://ssrn.com/abstract=3383367 or http://dx.doi.org/10.2139/ssrn.3383367

Martin Larch (Contact Author)

European Fiscal Board ( email )

Belgium
0032 2 2969244 (Phone)

Diederik Kumps

Vrije Universiteit Brussel ( email )

Pleinlaan 2
Brussels, Brabant 1050
Belgium

Alessandro Cugnasca

European Union - European Commission ( email )

Rue de la Loi 200
Brussels, B-1049
Belgium

Eloise Orseau

European Union - European Commission ( email )

Rue de la Loi 200
Brussels, B-1049
Belgium

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