Potential Output Pessimism and Austerity in the European Union

Pei Kuang*, Kaushik Mitra*

*Corresponding author for this work

Research output: Contribution to journalArticlepeer-review

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Abstract

The paper develops a business cycle model with policymakers' learning about potential output to analyze the European recession following the Global Financial Crisis. The initial recession led to overpessimism about potential output and cyclically adjusted budget balance (CAB), triggering fiscal austerity. The austerity caused further recession, which reinforced potential output and CAB pessimism, requiring continued austerity. The mutual reinforcement between pessimism and austerity contributed to the prolonged recession. The model replicates new findings regarding revisions to potential output estimates and the relationship between fiscal consolidation and policymakers' beliefs. Without policymakers' overpessimism, Eurozone GDP would have been 4.5% higher in 2012.
Original languageEnglish
JournalJournal of Money, Credit and Banking
Early online date27 Nov 2024
DOIs
Publication statusE-pub ahead of print - 27 Nov 2024

Keywords

  • structural fiscal balance
  • pessimism
  • potential output
  • debt brake
  • learning

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