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WP 2004/7 Gábor P. Kiss – Gábor Vadas: Mind the Gap – Watch the Ways of Cyclical Adjustment of the Budget Balance

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Abstract

Cyclically adjusted budget deficit (CAB) is a widely cited and used concept in the evaluation of fiscal situation. The key idea behind it is to separate temporary and/or non-discretionary effects on budget deficit from the underlying balance and/or effects of discretionary measures of fiscal policy. The computation of CAB is based on the identification of potential level of economic variables. In this paper we demonstrate, that composition matters both in the case of real and nominal variables. Both European Commission and European Central Bank propose methods for measuring CAB, however, they are not fully capable of satisfying all requirements. Besides, results show that aggregated and disaggregated approaches provide different estimations for the benefit of the latter. In this paper we present an alternative method, which is able to incorporate the advantages of both approaches. Combining output gap from production function and constrained multivariate HP filter induces theoretically motivated disaggregated approach where we also exploit the implication of production function parameterisation. Taking into account nominal features, for example nominal elements of the tax code or deflators directly affected by the government, the more precise definition of discretionary measures became also important.

JEL Classification Number: H62, E32

Keywords: cyclically adjusted budget deficit, price gap, business cycles, constrained multivariate HP filter

WP 2004_7