Abstract
The outbreak of the COVID-19 pandemic has caused an upsurge economic policy uncertainty (EPU). Study on the time-varying effect of EPU is of substantial implication for the central bank in implementation of monetary policy. To empirically investigate the time-varying effect of EPU, the paper considers the shock of the monetary policy implemented by China's central bank on different economic variables including interest rate, output gap, and inflationary gap using the latent threshold time-varying parameter vector autoregressive model (LT-TVP-VAR Model). Data period is chosen to be January 2015 through April 2021. Our findings show that (i) EPU has a significant threshold effect on the shock of quantitative monetary policy instrument and the shock of price-based monetary policy, and that the two types of policy are positively correlated; (ii) the price-based monetary policy instrument has a significant counter-cyclical effect on both output gap and inflationary gap; (iii) relative to the quantitative monetary policy instrument, the price-based monetary policy instrument has a more significant counter-cyclical effect on output gap; and (iv) a higher level of EPU is associated with a more significant monetary policy effect on output gap and inflationary gap.
Highlights
The outbreak of the COVID-19 pandemic in 2020 has caused tremendous shocks on society
The existing research related to this paper involves primarily the topics on the definition of economic policy uncertainty (EPU), the shock caused by EPU, monetary policy adjustment mechanism, and the correlation of EPU with monetary policy
The Akaike information criterion (AIC) minimum value is used and it shows that the model has a second-order lag
Summary
The outbreak of the COVID-19 pandemic in 2020 has caused tremendous shocks on society. As the level of EPU increases, it tends to discourages investment and consumption and make financial institutions reduce business credit, which might result in a higher unemployment rate and slow economic growth It is vitally important for the central bank to improve monetary policy effectiveness and reduce EPU as the goals of monetary policy typically include price stability, job creation, balance of international payments, and output growth. In this context, research on the time-varying effect of economic uncertainty is of considerable policy implications for the central bank in monetary policy.
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