Working Paper No. 13-41 the Political Polarization Index

American politics have become increasingly polarized in recent decades. To the extent that political polarization introduces uncertainty about economic policy, this pattern may have adversely affected the economy. According to existing theories, a rise in the volatility of fiscal shocks faced by individuals should result in a decline in economic activity. Moreover, if polarization is high around election dates, businesses and households may be induced to delay decisions that involve high reversibility costs (such as investment or hiring under search costs). Testing these theories has been challenging given the low frequency at which existing polarization measures have been computed (in most studies, the series is available only biannually). In this paper, I provide a novel high-frequency measure of polarization, the political polarization index (PPI). The measure is constructed monthly for the period 1981-2013 using a search-based approach. I document that while the PPI fluctuates around a constant mean for most of the sample period prior to 2007, it has exhibited a steep increasing trend since the Great Recession. Evaluating the effects of this increase using a simple VAR, I find that an innovation to polarization significantly discourages investment, output, and employment. Moreover, these declines are persistent, which may help explain the slow recovery observed since the 2007 recession ended. JEL Classification: E3, H3