The Role of Uncertainty in the Great Recession

July 2, 2014

Since the Great Recession, uncertainty about fiscal policy has slowed recovery in the U.S. economy, and little consensus exists among policymakers about what to do going forward, write Jesús Fernández-Villaverde, Pablo Guerrón-Quintana, Keith Keuster and Juan Rubio-Ramírez for the Cato Institute.

The researchers created a model to investigate whether increased uncertainty about fiscal policy (including government spending and tax increases or cuts) has a detrimental impact on economic activity. They found:

  • Fiscal uncertainty reduces output, consumption and investment. Additionally, working hours drop and remain flat for several quarters due to uncertainty.
  • Uncertainty regarding the capital-income-tax rate has the same negative effect on output as does a significant (30-point) increase in the federal funds rate -- the interest rate on short-term borrowing between banks.
  • When the economy has very low nominal interest rates (as the United States does now), the effects of uncertainty are magnified, lowering output by 1.7 percent and investment by 7.9 percent.

The study notes that uncertainty in fiscal policy is especially important when interest rates hit the zero lower bound, because the interest rate cannot drop to ameliorate the problems caused by fiscal uncertainty.

Source: Jesús Fernández-Villaverde, Pablo Guerrón-Quintana, Keith Keuster and Juan Rubio-Ramírez, "Fiscal Uncertainty and Economic Activity," Cato Institute, June 2014. 

 

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