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.