Fiscal Volatility Shocks and Economic Activity

We study how unexpected changes in uncertainty about fiscal policy affect economic activity. First, we estimate tax and spending processes for the United States with time-varying volatility to uncover evidence of time-varying volatility. Second, we estimate a VAR for the US economy using the time-varying volatility found in the previous step. Third, we feed the tax and spending processes into an otherwise standard New Keynesian model. Both in the VAR and in the model, we find that unexpected changes in fiscal volatility shocks can have a sizable adverse effect on economic activity. An endogenous increase in markups is a key mechanism.