If in attempting to estimate the cyclical component of a government fiscal outcome we underestimate the potential capacity of an economy, we will conclude that the government's discretionary fiscal position is less expansionary than it actually is.
Answer: False
The answer is False.
The implicit estimates of potential GDP that are produced by central banks, treasuries and other bodies like the IMF and the OECD are typically too pessimistic.
The reason is that they typically use the NAIRU to compute the "full capacity" or potential level of output which is then used as a benchmark to compare actual output against. The reason? To determine whether there is a positive output gap (actual output below potential output) or a negative output gap (actual output above potential output).
These measurements are then used to decompose the actual fiscal outcome at any point in time into structural and cyclical fiscal balances. The fiscal components are adjusted to what they would be at the potential or full capacity level of output.
So if the economy is operating below capacity then tax revenue would be below its potential level and welfare spending would be above. In other words, the fiscal balance would be smaller at potential output relative to its current value if the economy was operating below full capacity. The adjustments would work in reverse should the economy be operating above full capacity.
If the fiscal outcome is in deficit when computed at the "full employment" or potential output level, then we call this a structural deficit and it means that the overall impact of discretionary fiscal policy is expansionary irrespective of what the actual fiscal outcome is presently. If it is in surplus, then we have a structural surplus and it means that the overall impact of discretionary fiscal policy is contractionary irrespective of what the actual fiscal outcome is presently.
So you could have a downturn which drives the fiscal outcome into a deficit but the underlying structural position could be contractionary (that is, a surplus). And vice versa.
The difference between the actual fiscal outcome and the structural component is then considered to be the cyclical fiscal outcome and it arises because the economy is deviating from its potential.
As you can see, the estimation of the benchmark is thus a crucial component in the decomposition of the fiscal outcome and the interpretation we place on the fiscal policy stance.
If the benchmark (potential output) is estimated to be below what it truly is, then a sluggish economy will be closer to potential than if you used the true full employment level of output. Under these circumstances, one would conclude that the fiscal stance was more expansionary than it truly was.
This is very important because the political pressures may then lead to discretionary cut backs to "reign in the structural deficit" even though it is highly possible that at that point in time, the structural component is actually in surplus and therefore constraining growth.
The mainstream methodology involved in estimating potential output almost always uses some notion of a NAIRU which itself is unobserved. The NAIRU estimates produced by various agencies (OECD, IMF etc) always inflate the true full employment unemployment rate and completely ignore underemployment, which has risen sharply over the last 20 years.
The point is that by reducing the potential GDP estimates (by inflating the estimate of full employment unemployment) the structural deficits always contain some cyclical component and suggest that the discretionary policy choice is more expansionary than what it truly is when calibrated against a more meaningful potential GDP measure.
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