Fiscal Policy and Uncertainty

Abstract

We investigate the impact of macroeconomic uncertainty on the stimulative effect of government spending. Using historical macroeconomic time series, we show that government spending multipliers are smaller in episodes characterized by high macroeconomic uncertainty. This state dependence is found to be both statistically and economically significant. We then build a DSGE model with an agency problem subject to time varying levels of uncertainty. We solve the model via higher-order perturbation and use the model to evaluate state-dependent government stimulus. We find significant state-dependence in multipliers which qualitatively matches our empirical results. We conclude that uncertainty plays a significant role in determining the effectiveness of fiscal policy and that business cycle models which abstract from uncertainty can produce misleading policy recommendations.