Abstract
AbstractWe 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.
Highlights
In the context of the Great Recession Economic Policy Uncertainty (EPU) has been recognized as a major driver of the business cycle
During the 1970s, the Great Inflation, the initial impact was relatively high but was followed by overshooting which dampened the net impact of the shock
During the Great Moderation EPU shocks had a smaller impact on the economy
Summary
In the context of the Great Recession Economic Policy Uncertainty (EPU) has been recognized as a major driver of the business cycle. In order to address the second problem we follow Korobilis (2013) and augment our TVP-VAR with a few factors which capture information from a large data set 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 and on variables which mirror the activity on financial markets. Castelnuovo et al (2017) use an interacted VAR model and examine whether the effects of uncertainty are greater when the economy is at the zero lower bound While these approaches have their individual appeal, we stress that we neither have to define ex ante a certain number of regimes, nor do we have to condition on a threshold variable, such as recession/ non-recession or a certain stance of monetary policy.
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