Output Gap Uncertainty and the Optimal Fiscal Policy in the EU

Abstract Using a novel dataset, I quantify the magnitude of the EU-27 countries’ output gap revisions in 2002–2014, and study the implications of this uncertainty for the optimal fiscal policy with a DSGE model. I find that taking into account the output gap uncertainty (i.e. the difficulty to distinguish between cyclical and trend shocks in real time) has large implications for both the net lending and fiscal policy. In the median EU country, the primary net lending turns mildly countercyclical; a feature that is consistent with the data, but contrasts with the procyclical net lending under the full output gap information. The optimal fiscal policy, as measured by the changes in the cyclically-adjusted budget balance (CAB), is cautious and turns from strongly to weakly countercyclical because of the uncertainty. During fiscal crises, the CAB is allowed to deteriorate less and the adjustment of the CAB is gradual, while underestimation of the uncertainty may lead to more volatile policy. The uncertainty generates a substantial amount of cross-country heterogeneity in the dynamics of the total net lending, but not so much in the CAB-based fiscal policy.