Uncertainty and the effectiveness of fiscal policy

During the Great Recession of 2007-2009 uncertainty in the United States reached historically high levels. This paper analyzes the effectiveness of fiscal policy under different uncertainty regimes in the U.S. High uncertainty is known to make economic agents postpone their decisions on consumption and investment (real-options channel), making economic policy less effective. We use several uncertainty measures in a threshold vector autoregressive model (TVAR) to endogenously estimate different uncertainty regimes. Then we analyze the effectiveness of different fiscal policy shocks in each uncertainty regime. We measure uncertainty using S&P 100 volatility index (VXO) and Baa corporate bond yield relative to yield on 10-year treasury constant maturity (Baa10ym). Our benchmark model consists of aggregate government spending, taxes, uncertainty, and GDP. In addition to the benchmark model, we estimate three extensions. First, we differentiate between government consumption, investment, and defense expenditures. Second, we check the robustness using two different measures of uncertainty – VXO and Baa10ym. Third, we compute impulse responses of GDP aggregates: consumption and investment. Nonlinear impulse response functions differentiate between positive and negative fiscal shocks, as well as between small and big fiscal shocks. Confidence intervals are obtained by bootstrapping in order to determine the statistical significance of impulse responses. This paper has five important findings. (1) We find that fiscal policy shocks have a much larger effect on the economy during periods of high uncertainty. (2) We also find that during periods of average or low uncertainty government spending shocks tend to crowd out private sector investment spending, but during periods of high uncertainty, after a one-year delay, government spending shocks “crowd-in” private sector investment expenditures. (3) We find large shocks typically do not have the same dollar for dollar effect on GDP as small shocks. That is, 2SD shocks tend to have only a 33-50% larger effect than 1SD shocks. (4) We find that expansionary tax shocks are not as powerful as contractionary tax shocks. And finally and perhaps most importantly (5) we find that government investment spending shocks are far more potent that government consumption and government defense spending shocks. This last result suggests that infrastructure investment expenditures are a much better way to stimulate the economy than other types of government spending.