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Fiscal Policy Stance in the European Union: The Impact of the Euro

Mencinger, Jernej and Aristovnik, Aleksander (2013): Fiscal Policy Stance in the European Union: The Impact of the Euro. Published in: Engineering Economics , Vol. 24, No. 1 (February 2013): pp. 52-62.

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Abstract

In the recent years there has been an intense discussion whether the actual behaviour of fiscal authorities is consistent with cyclical stabilization objectives. The question of the appropriate fiscal policy is gaining recognition especially for the countries of the euro area after entering the European Monetary Union (EMU). Therefore, the aim of this paper is to evaluate the activity of the fiscal policy before and after the entrance to the euro zone for each individual EMU country in 1995–2010 period. For this purpose we will use the cyclical adjusted balance, which is the common tool used to estimate fiscal policy stance. The analysis of the cyclically adjusted balance gives an additional insight into the former activity arrangements of the fiscal policy, which contributes to gauge the ex-post estimation of the fiscal policy. On this base we can determine the causes of general government budgets imbalance in the past. Despite this fact, we should be aware of some caveats in the assessment of cyclical adjusted balance, which appear due the inconsistency in measurement of output gap and potential GDP growth. To evaluate pro-cyclical or countercyclical fiscal policy stance we compare the dynamic evaluation of the cyclically adjusted balance and output gap. Namely, changes of the cyclically adjusted balance in consecutive years indicate the orientation of fiscal policy, i.e. the fiscal impulse. By comparing the change in the cyclically adjusted balance and output gap between individual years, which indicates fluctuations in the economic cycle, it is possible to assess the orientation of fiscal policy, i.e. the fiscal position. The fiscal policy can be considered as countercyclical if it is expansive in the situation of negative output gap and restrictive in the situation, when the actual growth of GDP is above its potential rate. On the other hand, fiscal policy is characterized to be pro-cyclical if in the situation of negative output gap the government uses restrictive fiscal instruments and when the fiscal policy reacts expansionary in the situation of positive output gap, where the actual output exceeds the estimated potential GDP. In the empirical analysis we evaluate the fiscal policy stance for each country of the euro area. In the assessment of government behaviour we cover 14 countries in the 1995–2010 period. The results of the analysis generally confirm that the fiscal policy in most euro-area member states became more expansionary in the period after entering the EMU. Moreover, these preliminary findings were partly confirmed by a statistical analysis which shows statistically significant differences in expansionary fiscal policy between the aforementioned sub-periods. In addition, we might also conclude the average fiscal stance is expansionary when actual output is above its potential level, which implies a pro-cyclical bias in times of prosperity, and that the fiscal stance tends to be predominantly counter-cyclical when actual output is below its potential level. These conclusions can be associated with asymmetric fiscal behaviour after entering the euro area because the response of fiscal authorities to cyclical conditions in the economy depends on whether good or bad times are prevailing. These assertions reflect some conclusions made in other similar studies.

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