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Fiscal stabilisation in real time: An exercise in risk management

Martin Larch (), Diederik Kumps and Alessandro Cugnasca

Economic Modelling, 2021, vol. 99, issue C

Abstract: Fiscal policy in the EU has been largely pro-cyclical. We propose an approach that supports more informed decision making aimed at stabilising output. Rather than relying on notoriously uncertain point estimates of the cycle, our approach is built around the management of risks: (i) launching discretionary measures to support or dampen aggregate demand when, in hindsight, no measures would have been required, versus (ii) remaining inactive when, in hindsight, a stabilisation measure would have been warranted. A rational policymaker can manage these risks by using information on past forecast errors and take stabilisation measures only when real-time estimates of the cycle exceed an optimal threshold. We show that the observed tendency to run pro-cyclical fiscal policies can reflect two complementary factors: a preference for activism combined with the desire to avert downside risks to growth, while putting a blind eye on upside risks.

Keywords: Fiscal stabilisation; Signalling approach; Pro-cyclical fiscal policy; Risk management; Real-time output gap estimates (search for similar items in EconPapers)
JEL-codes: E62 E63 H62 (search for similar items in EconPapers)
Date: 2021
References: View references in EconPapers View complete reference list from CitEc
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DOI: 10.1016/j.econmod.2021.03.013

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