DP8528 Fiscal Volatility Shocks and Economic Activity

Author(s): Jesús Fernández-Villaverde, Pablo A. Guerron-Quintana, Keith Kuester, Juan Francisco Rubio-Ramírez
Publication Date: August 2011
Keyword(s): DSGE models, fiscal policy, monetary policy, uncertainty
JEL(s): C11, E10, E30
Programme Areas: International Macroeconomics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=8528

We study the effects of changes in uncertainty about future fiscal policy on aggregate economic activity. Fiscal deficits and public debt have risen sharply in the wake of the financial crisis. While these developments make fiscal consolidation inevitable, there is considerable uncertainty about the policy mix and timing of such budgetary adjustment. To evaluate the consequences of this increased uncertainty, we first estimate tax and spending processes for the U.S. that allow for time-varying volatility. We then feed these processes into an otherwise standard New Keynesian business cycle model calibrated to the U.S. economy. We find that fiscal volatility shocks have an adverse effect on economic activity that is comparable to the effects of a 25-basis-point innovation in the federal funds rate.