A previous version of this working paper was originally published in August 2011.
In light of large fiscal deficits and high public debt levels in the U.S., a fiscal consolidation seems inevitable. However, there is notable uncertainty about the policy mix and timing of such a budgetary adjustment. To evaluate the consequences of the increased uncertainty, the authors first estimate tax and spending processes for the U.S. that allow for time-varying volatility. They then feed these processes into an otherwise standard New Keynesian business cycle model calibrated to the U.S. economy. The authors find that fiscal volatility shocks can have a sizable adverse effect on economic activity.