This report estimated cyclically adjusted budget balance (CABB) and potential GDP growth at the same time using a time series model (unobserved component model, UCM) that explicitly took the relationship between cyclical fluctuation and budget balance into account. Budget balance can be divided into cyclical budget balance (CBB), which is cycle-sensitive and functions as an automatic stabilizer, and CABB, which leaves out the cyclical factors. CABB can be interpreted as the budget balance attainable when an economy is utilizing resources at a normal level and in neither a recession nor a boom. In addition, the potential GDP —excluding the real GDP factors that can fluctuate because of temporary fiscal factors— can be interpreted as a fiscally neutral potential GDP.
In the conventional two-step approach, potential GDP is calculated first and then budget balace is divided into CBB and CABB using a statistical methodology based on regression analysis. In this research, potential GDP and the corresponding CABB are estimated simultaneously using a UCM that considers the theoretical relationship between three variables (budget balance, real GDP, and GDP deflator).
The analysis found that CABB and potential growth rate can be useful indicators for gauging the normal production level and fiscal space of the Korean economy over the medium-term time horizon, despite their vast uncertainty as unobserved variables in the estimation methodology.