Balancing Fiscal Policies Amid Output Gap Uncertainty in Emerging Economies

This IMF study explores how output gap uncertainty affects fiscal policy in emerging markets, revealing less counter-cyclical responses due to volatile data and institutional constraints. It suggests prioritizing economic stabilization over debt control to achieve faster recovery and long-term fiscal stability.

Authored by Giacomo Cattelan and Boaz Nandwa of the International Monetary Fund, the paper "Output Gap Uncertainty and Fiscal Policy Adjustment in Real-Time in Emerging Economies" delves into the complexities of fiscal policy responses in emerging markets (EMs). Using data from successive World Economic Outlook (WEO) reports spanning 1998 to 2022, the study highlights how fiscal policy in EMs grapples with the challenges posed by volatile and persistently negative output gap estimates. Compared to advanced economies (AEs), EMs face greater unpredictability in assessing their economic cycles, which has significant implications for the formulation and execution of counter-cyclical fiscal policies. This uncertainty, rooted in measurement errors and frequent data revisions, often leads to conservative fiscal responses, undermining their potential to stabilize economic fluctuations effectively.

Comparing Fiscal Policy Responses in Advanced and Emerging Economies

The study reveals a stark contrast between EMs and AEs regarding fiscal policy adjustments in response to output gap estimates. While AEs generally exhibit relatively stable and accurate real-time output gap assessments, enabling them to implement effective budgetary measures, EMs often struggle with greater volatility and persistent underestimation of economic upturns. This disparity results in EMs adopting weaker counter-cyclical policies. Policymakers in EMs, constrained by unreliable real-time data, tend to err on the side of caution to avoid exacerbating public debt. However, this restraint often leads to suboptimal fiscal adjustments, delaying economic recovery and increasing welfare costs. The cautious approach in EMs contrasts with the more responsive and effective fiscal measures observed in AEs, where real-time data is more reliable.

Simulating Fiscal Policies with a New Keynesian DSGE Model

To further explore the dynamics of fiscal responses, the researchers employed a New Keynesian Dynamic Stochastic General Equilibrium (DSGE) model calibrated to reflect the average behavior of an EM. The findings illustrate that when policymakers consider both the output gap and fiscal implementation uncertainties, their fiscal responses become less counter-cyclical. This conservative approach is driven by the dual concerns of stabilizing the economy and avoiding excessive public debt accumulation. The model suggests that such an approach leads to slower economic recovery and reduced output stabilization efficiency. In contrast, when policymakers focus primarily on addressing output gap uncertainty, they tend to adopt a more aggressive fiscal stance. This strategy results in faster economic stabilization but entails a short-term surge in public debt, which normalizes as the economy recovers and tax revenues rise. The analysis underscores the need for a nuanced approach that balances these competing priorities to achieve optimal outcomes.

Prioritizing Economic Stabilization Over Debt Management

The research suggests that EM policymakers could improve fiscal outcomes by recalibrating their policy objectives to prioritize output stabilization over strict debt management. By assigning greater weight to output gap stabilization in their decision-making, EMs can adopt more robust counter-cyclical fiscal measures, leading to quicker economic recovery and more stable long-term debt trajectories. The study highlights the inefficiencies introduced by excessive caution, suggesting that tolerating short-term debt increases can lead to better overall outcomes. A more proactive fiscal policy response, despite its initial cost, allows for faster stabilization of output and, ultimately, a healthier economic recovery. This approach aligns with the needs of EMs, which often face higher uncertainty and constrained fiscal capacities.

Addressing Structural Challenges and Improving Fiscal Resilience

The study emphasizes the structural challenges that exacerbate output gap uncertainty in EMs, such as poor data quality, frequent revisions, and weaker institutional frameworks. These factors significantly limit the ability of EM policymakers to respond effectively to economic shocks. Strengthening institutional capacities and improving data collection and forecasting mechanisms are vital to enhancing fiscal policy efficiency. Additionally, the research calls for caution in relying solely on real-time output gap estimates for policy formulation. Incorporating robust forecasting tools, scenario analyses, and sensitivity assessments can help mitigate the risks associated with policy errors. Such measures are particularly critical for EMs, where fiscal space is often limited, and policy missteps can have severe consequences.

A Call for Proactive Fiscal Policies in Emerging Markets

Overall, the paper offers valuable insights into the challenges and opportunities associated with fiscal policy adjustments in EMs. It provides a compelling case for rethinking the balance between output stabilization and debt management, advocating for a more proactive and flexible fiscal policy approach. By addressing the root causes of output gap uncertainty and focusing on structural improvements, EMs can enhance their resilience to economic shocks and achieve more sustainable growth trajectories. The findings underscore the importance of adaptive fiscal strategies, which prioritize economic stabilization without neglecting long-term fiscal sustainability. As EMs navigate the complexities of rising public debt and uncertain economic cycles, this research highlights the critical role of informed and decisive policymaking in fostering economic stability and growth.