Authors: Tero Kuusi
Published: May, 2015

One of the greatest challenges faced by counter-cyclical economic policy lies in recognising the nature of shocks affecting the economy. Economic policy should react to permanent structural shocks in a different manner than to temporary shocks of a cyclical nature. It is often sensible to counteract cyclical challenges by temporarily adjusting public expenditure and debt. The effect of such adjustments on the sustainability of public finances can be neutralised as the shock dissipates. On the other hand, a structural shock has long-term effects on the production potential of the economy or the sustainability of public finances (see for example Aguiar and Gopinath, 2007), and therefore requires immediate action, albeit action that takes account of the general sustainability of the current public finances and the multiplier effects of fiscal policy. Uncertainty about the nature of shocks may lead to conflicting policy recommendations, which in the worst case scenario can paralyse financial policy. For example, when the nature of a shock is cyclical, the reaction to an economic downturn should be expansive. If the shock is structural, the reaction should be contractionary.

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