Learning About Fiscal Policy and the Effects of Policy Uncertainty

Abstract

Reproduction permitted only if source is stated. ISBN 978-3-86558-991-0 (Internetversion) Non-technical summaryPartly motivated by the recent financial crisis and the subsequent recession, economists have recently placed greater emphasis on identifying uncertainty about monetary and fiscal policy as a potentially important factor determining economic outcomes, as highlighted by Baker, Bloom, and Davis (2012). Natural questions seem to be how this uncertainty arises, what the exact transmission mechanism is and how this uncertainty affects equilibrium outcomes. In this paper we propose one model of fiscal policy uncertainty: an RBC-type model with distortionary taxation and government debt, in which agents act as econometricians and update their beliefs about fiscal policy every period. In our model, agents use past realizations of fiscal variables to learn what actual policy rules in place and thus whether changes in those fiscal variables are temporary (driven by exogenous shocks) or permanent (driven by changes in the parameters of the fiscal policy rules). The task of disentangling permanent from temporary changes in fiscal policy is identified as a major source of fiscal policy uncertainty by Baker et al. (2012). In our model uncertainty about fiscal policy is partly endogenous since the properties of the estimators of the fiscal policy rule coefficients employed by private agents change as the private sector's behavior changes. This behavior occurs because choice variables of the representative private agent enter the fiscal policy rules.We analyze a one-time permanent change in the government spending policy rule and use Monte Carlo simulations of our model to assess how beliefs evolve and how these beliefs affect allocations. Learning leads to substantially different outcomes even though learning is quite fast: there is a substantial temporary spike in volatility under learning that is absent under full information. In addition, there are persistent average differences between the outcomes under learning and under full information. We show that investment plays a big role in creating the average differences -temporary differences in investment between the learning and full information environments have long-lasting effects via the capital stock. The uncertainty about government spending induces uncertainty about the steady state of other variables such as GDP and debt, which in turn influences uncertainty about the steady state of other fiscal policy instruments, even though the coefficients of those policy rules are tightly (and correctly) estimated. Thus, even though we only consider changing a small subset of the fiscal policy coefficients, this uncertainty creeps into other fiscal variables. As robustness checks we consider various assumptions about the agents' information set and their preferences as well as an alternative change in fiscal policy. Our qualitative results remain unchanged throughout. What sets our model apart is the way agents form their beliefs about the stance of fiscal policy. Our...

Uncertainty and Fiscal Cliffs

“…The information structure in this paper differs from other settings, such as Davig (), Hollmayr and Matthes (), or Richter and Throckmorton (), in which agents in the economy learn about the fiscal policy rule currently in place. Instead, in this paper, contemporaneous policy rules may be left unchanged, but the arrival of information shifts expectations over future rules.…”