Output Gap Uncertainty and Fiscal Policy Adjustment in Real-Time in Emerging Economies

IMF Working Papers, December 13, 2024

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Examines how uncertainty around real-time output gap estimates affects discretionary fiscal policy in emerging markets (EMs).
Uses successive vintages of the World Economic Outlook for emerging markets during 1998-2022 to analyze real-time reactions of fiscal policy to the economic cycle.
Calibrates a New Keynesian DSGE model to match the behavior of an average EM.

EMs tend to have persistently negative and significantly more volatile real-time output gap estimates compared to advanced economies (AEs).
EMs are less responsive to output gap shocks in real-time compared to AEs.

When EM policy makers are equally concerned about:
- uncertainty around output gap estimates, and
- fiscal implementation,
- then fiscal policy is less counter-cyclical than the benchmark case with no uncertainty, entailing an efficiency loss for the purpose of output gap stabilization.
When the concern is only about output gap uncertainty:
- EM policy makers tend to react more counter-cyclically,
- at a cost of public debt spiking in the short term and stabilizing over the long term.
- This implies it might be optimal for EM policy makers to act more aggressively to stabilize the economy.
By adjusting the relative importance of output gap versus debt stabilization in their objective function, EM policy makers can achieve a similar outcome as in the benchmark case with no uncertainty.

Consideration of output gap estimate uncertainty should affect fiscal response design in EMs.
Balancing the trade-off between output gap stabilization and public debt dynamics is crucial:
- Stronger counter-cyclical fiscal responses can improve output stabilization but may cause short-term public debt spikes.
- Adjusting objective function weights on output gap versus debt stabilization can restore outcomes similar to an uncertainty-free benchmark.
EM policy makers may need to act more aggressively on output stabilization when uncertainty is primarily about the output gap, while managing implementation risks when those are also a concern.

Subject: Economic theory, Expenditure, Fiscal policy, Fiscal stance, Neoclassical theory, Output gap, Production, Public debt
Keywords: Fiscal policy, fiscal policy adjustment, Fiscal stance, Neoclassical theory, Output gap, output gap estimate, output gap shock, output gap uncertainty, public debt, real-time output gap, real-time output gap estimates