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 vector autoregression (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. After confirming that all EPU series posted in policyuncertainty.com are fractionally integrated processes, 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. In addition, I investigate the effect of EPU on output 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 tend to be smaller in magnitude. Treating long memory, therefore, is important for accurate estimation of the dynamic effects.