Output Gap Uncertainty, Sovereign Risk Premia and the Contingent Importance of the Bond Vigilantes

ABSTRACT This paper investigates the implications of output gap uncertainty for the conduct of fiscal policy using a small‐scale macroeconomic model with boundedly rational agents. Specifically, agents use an adaptive updating mechanism to approximate the unobservable potential output that suffers, similarly to the Hodrick and Prescott (1997) filter, from an end‐point bias. This generates an unintendedly procyclical fiscal policy that affects the government's credibility and by extension the sovereign risk premium. Our simulations highlight the importance of this so‐called bond vigilantes channel, as well as of the government's credibility among financial markets, for the sustainability of government debt and for macroeconomic stability.