On the Time‐Varying Effects of Economic Policy Uncertainty on the US Economy
| Author | Alexander Schlösser,Jan Prüser |
| Date | 01 October 2020 |
| DOI | http://doi.org/10.1111/obes.12380 |
| Published date | 01 October 2020 |
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©2020 TheAuthors. OxfordBulletin of Economics and Statistics published by Oxford University and John Wiley & Sons Ltd.
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OXFORD BULLETIN OF ECONOMICSAND STATISTICS, 82, 5 (2020) 0305–9049
doi: 10.1111/obes.12380
On the Time-Varying Effects of Economic Policy
Uncertainty on the US Economy*
Jan Pr ¨
user,†,‡ Alexander Schl ¨
osser†
†Faculty of Economics and Business Administration, University of Duisburg-Essen,
Universit¨atsstraße 12,45117, Essen, Germany (e-mail: jan.prueser@rgs-econ.de)
‡Ruhr Graduate School in Economics, RWI - Leibniz Institute for Economic Research,
Germany
Abstract
We study the impact of Economic Policy Uncertainty (EPU) on the US Economy by using
a VAR with time-varying coefficients. The coefficients are allowed to evolve gradually
over time which allows us to discover structural changes without imposing them a priori.
We find three different regimes, which match the three major periods of the US economy,
namely the Great Inflation, the Great Moderation and the Great Recession. The initial
impact on real GDP ranges between −0.2% for the Great Inflation and Great Recession
and −0.15% for the Great Moderation. In addition, the adverse effects of EPU are more
persistent during the Great Recession providing an explanation for the slow recovery. This
regime dependence is unique for EPU as the macroeconomic consequences of Financial
Uncertainty turn out to be rather time invariant.
I. Introduction
In the context of the Great Recession uncertainty has regained attention as a major driver
of the business cycle. A high degree of uncertainty has the potential to dampen economic
activity.However,measuring uncertainty is a challenging task. Therefore, it is not surprising
that the literature provides several ways to quantify the level of uncertainty. One way
to proxy a certain type of uncertainty is pioneered by Baker, Bloom and Davis (2016).
They propose a newspaper-based index called Economic Policy Uncertainty (EPU) and
provide empirical evidence that EPU shocks cause a decline in both, employment and
industrial production. Based on this and other indices, a growing literature established
further empirical evidence that uncertainty has a negative impact on economic activity,
for example, Bloom (2009), Baker, Bloom and Davis (2012), Mumtaz and Zanetti (2013),
Caldara et al. (2016) or Mumtaz and Surico (2018). We contribute to this literature by
investigating whether the effect of EPU on the US economy is time varying. Therefore,
JEL Classification numbers: C11, C32, E20, E60
*We thank FrancescoZanetti and three anonymous referees as well as the participants of the Rimini Conference
in Economics and Finance (RCEF2018), Volker Clausen and Christoph Hanck for valuable comments.
1218 Bulletin
this study puts emphasis on the adverse macroeconomic effects of EPU in dependence
to the three major periods of the US economy, namely the Great Inflation (1965–82), the
Great Moderation (1982–2007) and the Great Recession and its aftermath (2007-).1
To model the possibly time-varying impact of EPU shocks on the economy we use
the time-varying parameter VAR (TVP-VAR) of Primiceri (2005). In the TVP-VAR the
coefficients are allowed to evolve gradually over time. Thereby, it is possible to detect
structural changes without imposing them a priori. However, this flexible structure does
not come without costs. First, it bears a high risk of overfitting and, second, estimation is
only feasible with a small number of variables. The first problem is typically tackled by
imposing tight priors, which regularize the amount of time variation.The strength of these
priors depends on a small set of hyperparameters, which have to be set by the researcher.
The ideal choice is, however, subject to a trade-off. While an overly loose prior may result
in overfitting, an overly tight prior may suppress possible time variation, which we want
to discover. Most applications of the TVP-VAR use fixed values for the hyperparameters
on an ad hoc basis or the values used by Primiceri (2005). It is, however, unclear whether
these values should be employed in investigating uncertainty shocks. Moreover, previous
applications do not take into account that estimation uncertainty about these hyperparam-
eters may influence inference. We therefore estimate these hyperparameters using a fully
Bayesian approach proposed by Amir-Ahmadi, Matthes and Wang (2020). We find that
estimating the hyperparameters is important since using the benchmark values of Prim-
iceri (2005) would suppress some amount of time variation. In order to address the second
problem, we followKorobilis (2013) and augment our TVP-VAR with a few factors, which
capture information from a large panel of macroeconomic and financial variables without
introducing a degrees of freedom problem, instead of selecting a few variables from over
100 potential variables. This enables us to investigate simultaneously the impact of EPU
on variables, which represent real economic activity. This step turns out to be empirically
relevant since EPU has an impact on a wide range of different variables.
Our main contribution is that we provide empirical evidence of a time-varying impact
of EPU on real activity in the US economy by calculating time-varying impulse response
functions, which are allowed to change at each point in time. It turns out that the time-
varying impulse responses vary considerably for real GDP. During the 1970s, the time
of the Great Inflation, the initial impact was relatively high (−0.2%) but was followed
by overshooting. During the Great Moderation, EPU shocks had a smaller impact on the
economy (−0.15%). Finally, during the Great Recession, the initial impact of EPU shocks
again increased in size (−0.2%) and had a persistent effect on the economy, preventing
a quick recovery. We therefore find three different regimes which match the three major
periods of the US economy, namelythe Great Inflation, the Great Moderation and the Great
Recession. While there is a large literature which finds that uncertainty shocks are more
powerful if the economy is in extreme conditions (see citation below), such as an economic
recession and high financial stress, previous literature has ignored whether this effect is
credible in a statistical sense. In order to fill this gap in the literature, we provide credible
bands for the difference across the three regime-dependent impulse response functions.
1A comprehensive overview about the major economic and political circumstances during those periods can be
found at Federal Reserve History.
©2020 The Authors. Oxford Bulletin of Economics and Statistics published by Oxford University and JohnWiley & Sons Ltd.
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