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Uncertainty and fiscal cliffs

Author

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  • Davig, Troy A.

    () (Federal Reserve Bank of Kansas City)

  • Foerster, Andrew T.

    (Federal Reserve Bank of Kansas City)

Abstract

Motivated by the US Fiscal Cliff in 2012, this paper considers the short- and longer- term impact of uncertainty generated by fiscal policy. Empirical evidence shows increases in economic policy uncertainty lower investment and employment. Investment that is longer-lived and subject to a longer planning horizon responds to policy uncertainty with a lag, while capital that depreciates more quickly and can be installed with few costs falls immediately. A DSGE model incorporating uncertainty over future tax regimes produces responses to fiscal uncertainty that match key features of the data. The model features uncertainty over the average tax rate and rational expectations about the resolution of uncertainty with specific outcomes and timing. Uncertainty injects noise into the economy and lowers the level of economic activity.

Suggested Citation

  • Davig, Troy A. & Foerster, Andrew T., 2014. "Uncertainty and fiscal cliffs," Research Working Paper RWP 14-4, Federal Reserve Bank of Kansas City.
  • Handle: RePEc:fip:fedkrw:rwp14-04
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    References listed on IDEAS

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    Cited by:

    1. Shoag, Daniel & Veuger, Stan, 2016. "Uncertainty and the geography of the great recession," Journal of Monetary Economics, Elsevier, vol. 84(C), pages 84-93.
    2. Richter, Alexander W. & Throckmorton, Nathaniel A., 2015. "The consequences of an unknown debt target," European Economic Review, Elsevier, vol. 78(C), pages 76-96.
    3. Murray, James, 2014. "Fiscal Policy Uncertainty and Its Macroeconomic Consequences," MPRA Paper 57409, University Library of Munich, Germany.
    4. Richter, Alexander W., 2015. "Finite lifetimes, long-term debt and the fiscal limit," Journal of Economic Dynamics and Control, Elsevier, vol. 51(C), pages 180-203.
    5. Bi, Huixin & Shen, Wenyi & Yang, Shu-Chun S., 2016. "Debt-dependent effects of fiscal expansions," European Economic Review, Elsevier, vol. 88(C), pages 142-157.
    6. Frank N. Caliendo & Aspen Gorry & Sita Slavov, 2015. "The Cost of Uncertainty about the Timing of Social Security Reform," NBER Working Papers 21585, National Bureau of Economic Research, Inc.
    7. Foerster, Andrew T., 2014. "The asymmetric effects of uncertainty," Economic Review, Federal Reserve Bank of Kansas City, issue Q III, pages 5-26.
    8. Ricco, Giovanni & Callegari, Giovanni & Cimadomo, Jacopo, 2014. "Signals from the Government: Policy Uncertainty and the Transmission of Fiscal Shocks," MPRA Paper 56136, University Library of Munich, Germany.

    More about this item

    Keywords

    Fiscal policy; Uncertainty; Distorting taxation;

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