The Effect of Economic Policy Uncertainty Under Fractional Integration

One of the most popular measures of economic policy uncertainty (EPU) is an index based on newspapers coverage of particular keywords. The constructed index is often then included in VAR models to examine the extent to which EPU affects economic activity. Researchers, however, have not investigated how the possibility of fractional integration in this index may affect the results. Under fractional integration, the effects of EPU on output in a standard VAR setting may be biased. In this paper, I first show that all EPU series posted in policyuncertainty.com are indeed fractionally integrated processes. In addition, I show that the residuals from Baker, Bloom, and Davis (2016)’s VAR model that includes output, EPU, and other covariates are also fractionally integrated. Next, I estimate a fractionally cointegrated VAR (FCVAR) model to evaluate the dynamic effects of EPU. Likelihood ratio tests indicate that fractional cointegration cannot be rejected at low lag orders. Lastly, I investigate the effect of EPU on ouput after applying various filters to remove the long-memory component. While I still find that EPU imparts a negative effect on output, relative to Baker et al. (2016)’s results, the effects are 50 to 90% smaller in magnitude and take place several months sooner. Long memory, therefore, appears to explain the bulk of the dynamic effect.