Fiscal policy uncertainty and the business cycle: Time series evidence from Italy

Economic uncertainty is an important factor behind macroeconomic fluctuations: in an uncertain environment, firms reduce hiring and investment; financial intermediaries are more reluctant to lend; households increase their propensity to save. In the present paper, we study the effects of the uncertainty which arises from fiscal policy decisions and propose a new measure of fiscal policy uncertainty (FPU). In particular, we estimate a fiscal reaction function, allowing the volatility of the shocks to be time-varying. The time series of this volatility is our proxy for FPU. Looking at Italian data over the period 1981–2014, we find that an unexpected increase in our measure of FPU has a negative impact on the economy. One implication of this result is that the same change in the government budget can have different effects depending on whether it is associated with a reduction or an increase in FPU. Therefore, the neglect of FPU may partly explain why the size (and sign) of fiscal multipliers differs so much across existing empirical studies.