Policy Risk and the Business Cycle

The argument that policy risk, i.e., uncertainty about monetary and fiscal policy, has been holding back the economic recovery in the U.S. during the Great Recession has a large popular appeal. We analyze the role of policy risk in explaining business cycle fluctuations by using an estimated New Keynesian model featuring policy risk as well as uncertainty about technology. We directly measure uncertainty from aggregate time series and find considerable evidence of time-varying policy risk in the data. However, the “pure uncertainty”-effect of policy risk is unlikely to play a major role in business cycle fluctuations. In the estimated model, output effects are relatively small because the aggregate policy risk shocks are i) too small and ii) not sufficiently amplified.