Potential Output Pessimism and Austerity in the European Union

Pei Kuang and Kaushik Mitra
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Pei Kuang: University of Birmingham

Discussion Papers from Department of Economics, 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.

Keywords: Structural fiscal balance; learning; debt brake; pessimism; potential output (search for similar items in EconPapers)
JEL-codes: D84 E62 (search for similar items in EconPapers)
Pages: 70 pages
Date: 2022-07
New Economics Papers: this item is included in nep-eec and nep-mac
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Persistent link: https://EconPapers.repec.org/RePEc:bir:birmec:22-08

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