Estimation of Cyclically Adjusted Fiscal Balance and the Potential Growth Rate
Published on 18 June 2021
Published by Macro-Economic Analysis Division
An estimation of the cyclically adjusted fiscal balance and the potential growth rate was made simultaneously, by using a time series model (unobserved component model) explicitly taking into consideration the relationship between business cycles and fiscal balance. Fiscal balance reacts sensitively to business cycles, and can be categorized into cyclical fiscal balance which functions as an automatic economic stabilizer and cyclically adjusted fiscal balance which leaves out the cyclical factors. Cyclically adjusted fiscal balance can be understood as the fiscal balance attainable under economic conditions that are neither depressed nor booming, when an economy utilizes its resources at a normal level. Also, the potential GDP - which excludes real GDP factors that may differ from temporary fiscal factors – can be understood as a fiscally-neutral potential GDP level.
According to the traditional two-stage approach, the potential GDP is estimated in stage 1, which is broken down into cyclical fiscal balance and cyclically adjusted fiscal balance in the following stage, via statistical methodology based on regression analysis. Here, by using an unobserved component model considering the theoretical relationship between three variables (fiscal balance, real GDP and GDP deflator), a simultaneous estimation was made of the potential GDP and its corresponding cyclically adjusted fiscal balance. The analysis concluded that despite the limitation of high uncertainty resulting from the estimation methodology applied with unobserved variables, the cyclically adjusted fiscal balance and the potential growth rate were confirmed to be useful as indicators for gauging the normal production level and fiscal space of the Korean economy over the medium-term time horizon.
As the impact of public finance on economic growth and business cycles has grown since the global financial crisis, fiscal policy must find the appropriate combination of boosting mid-to-long term potential growth rates and attaining near-term economic stabilization, while ensuring sustainability. As the government has decided to introduce a set of fiscal rules and regulations regarding overall fiscal performance indicators such as government debt ratios and the balance of consolidated public sector finance beginning in 2025, this study may serve as a useful starting point for discussing more concrete and efficient fiscal management objectives. Analyzing the impact of changes in job market conditions or income distribution on fiscal balance by adding an unemployment rate variable or income distribution index remains an important research topic.