ABSTRACT
This chapter addresses issues concerning the uncertainty surrounding estimates of the output gap and, in turn, the cyclically adjusted budget deficit. Uncertainty about the size of the output gap is likely to be reflected in uncertainty about the size of the cyclical adjustment to be applied to the budget deficit. Our main objective in this chapter is to evaluate the uncertainty associated with a commonly used estimate of the output gap and to demonstrate how this should be reflected in uncertainty about the cyclically adjusted budget deficit. The degree of uncertainty associated with the estimate of the output gap for a period in the past, when computed now, is noticeably less than that associated with the estimate of the current (or real-time) gap. Since typically policy makers are concerned about the current gap, we focus on evaluation of real-time estimates and their uncertainty. Uncertainty about the cyclically adjusted budget deficit is further compounded by uncertainty over the link between the output gap and the budget deficit. If the gap were to be caused by tax rich elements of demand, such as consumption, then the impact of a given gap on the deficit would be larger than when the gap is caused by changes in a tax poor component of demand, such as exports. We therefore undertake a further analysis of the sources of shocks and study their impact on the uncertainty surrounding the budget deficit. In the second section of the chapter we discuss methods of estimating the output gap and
the associated uncertainty. We focus on the Harvey-Trimbur (Harvey and Trimbur 2003) estimator, which approximates a parametric version of the ideal band pass filter discussed in Baxter and King (1999). We utilize this estimator in part because it allows an analytical derivation of its standard deviation, which we present in this section. We then present and evaluate real-time estimates of the output gap and the associated uncertainty for the UK, Germany, France, Italy, Spain, the Netherlands and Belgium. In the third section we calculate the cyclically adjusted budget deficits from the real-time output gap data and present uncertainty bands around these estimates. The fourth section looks at the sensitivity of our results, by applying different coefficients from a model-based analysis of multipliers to the output gap in the calculation of the cyclically adjusted deficit. The final section draws conclusions about the difficulties associated with producing reliable estimates of the cyclically adjusted budget deficit.
Model uncertainty
