Abstract
This paper uses causal graphs to test for the direction of instantaneous causality between economic policy uncertainty (EPU) and stock market volatility. The paper derives simple test regressions from a causal graph, applies the regressions to data for 23 countries, and shows how causal graphs can be used to examine the robustness of the results. The empirical results imply that stock market volatility is not a cause of EPU and that domestic EPU and US EPU are often instantaneous causes of stock market volatility. A comparison of the graph-based approach with a VAR-based causality analysis demonstrates that both approaches yield consistent statistical results. However, in contrast with the VAR approach, the graph-based approach utilizes the additional information provided by the causal graph to infer the direction of instantaneous causality.
This is a preview of subscription content, log in via an institution to check access.
Similar content being viewed by others
Notes
Note that examining instantaneous causality is more ambitious than establishing Granger causality (Granger 1969), that is, to find out whether \(x_{t-1}\) helps predicting \(y_{t}\) or whether \(y_{t-1}\) helps predicting \(x_{t}\). For a discussion of Granger causality with causal graphs, see Peters et al. (2017), chap. 10.
The set of variables z may contain variables from period t as well as variables from former periods including lags of \(x_t\).
The d in the term d-separation stands for “directional."
Chap. 6 in Peters et al. (2017) provides a formal treatment.
To avoid clutter, all incoming arrows into the variables in \(m-1\) originating in \(m-2\) and all outgoing arrows in m pointing to variables in \(m+1\) are suppressed. Unsystematic causes in \(m-1\) are also suppressed in Fig. 2 and will be suppressed in all DAGs from now on.
More general assumptions would require more sophisticated conditional independence tests. The basic steps of the procedure remain the same, however.
A rather unlikely scenario, not considered in the DAG in Fig. 2, where \(b_{1} \ne 0\) and \(c_{1} = 0\) or \(d_{1} = 0\) should be mentioned for completeness. In this scenario, EPU and stock market volatility would be completely unrelated and jointly determined by a third variable. For example, domestic EPU and stock market volatility would be correlated only because of a common cause z, i.e., \(x_m \leftarrow z_m \rightarrow y_m\). Here \(y_m\) would be a collider along the path (\(y_{m-1} y_{m}, z_{m}, x_{m}\)).
For the USA, for instance, the keywords are:“economic” or “economy,” “uncertain” or “uncertainty” and at least one of the terms “congress,” “deficit,” “Federal Reserve,” “legislation,” or “White House.” Baker et al. (2016) provide details about the country-specific EPU indices, which are available at http://www.policyuncertainty.com/.
It is important to note that a DAG need not contain all variables that might play a role in determining a variable of interest. What a DAG should contain are the variables that are important to answering the research question. For a good discussion of this issue, see Huntington-Klein (2021), chap. 7.
All results are available upon request.
The full results of the regressions and the specification tests are available upon request.
References
Ajmi AN, Aye GC, Balcilar M, El Montasser G, Gupta R (2015) Causality between US economic policy and equity market uncertainties: evidence from linear and nonlinear tests. J Appl Econ 18(2):225–246
Antonakakis N, Chatziantoniou I, Filis G (2013) Dynamic co-movements of stock market returns, implied volatility and policy uncertainty. Econ Lett 120(1):87–92
Baker SR, Bloom N, Davis SJ (2016) Measuring economic policy uncertainty. Q J Econ 131(4):1593–1636
Baker SR, Bloom N, Davis SJ, Kost KJ (2019) Policy news and stock market volatility. Working Paper 25720, National Bureau of Economic Research. http://www.nber.org/papers/w25720
Balli F, Uddin GS, Mudassar H, Yoon SM (2017) Cross-country determinants of economic policy uncertainty spillovers. Econ Lett 156:179–183
Bloom N (2009) The impact of uncertainty shocks. Econometrica 77(3):623–685
Bloom N, Floetotto M, Jaimovich N, Saporta-Eksten I, Terry SJ (2018) Really uncertain business cycles. Econometrica 86(3):1031–1065. https://doi.org/10.3982/ECTA10927
Boutchkova M, Doshi H, Durnev A, Molchanov A (2012) Precarious politics and return volatility. Rev Financ Stud 25(4):1111–1154
Caggiano G, Castelnuovo E, Figueres JM (2020) Economic policy uncertainty spillovers in booms and busts. Oxf Bull Econ Stat 82(1):125–155
Caldara D, Fuentes-Albero C, Gilchrist S, Zakrajšek E (2016) The macroeconomic impact of financial and uncertainty shocks. Eur Econ Rev 88:185–207
Christoffersen PF, Diebold FX (2000) How relevant is volatility forecasting for financial risk management? Rev Econ Stat 82(1):12–22
Colombo V (2013) Economic policy uncertainty in the US: does it matter for the euro area? Econ Lett 121(1):39–42
Cunningham S (2021) Causal inference. Yale University Press, London
Ederington LH, Guan W (2005) Forecasting volatility. J Futur Mark 25(5):465–490. https://doi.org/10.1002/fut.20146
Engle RF (1982) Autoregressive conditional heteroscedasticity with estimates of the variance of United Kingdom inflation. Econometrica 50(4):987–1007
Gabauer D, Gupta R (2018) On the transmission mechanism of country-specific and international economic uncertainty spillovers: evidence from a tvp-var connectedness decomposition approach. Econ Lett 171:63–71
Gerlach S, Ramaswamy S, Scatigna M (2006) 150 years of financial market volatility. BIS Q Rev September 2006, 77–91. https://ssrn.com/abstract=1632414
Gourieroux C, Monfort A, Christian G (1997) Time series and dynamic models, vol 3. Cambridge University Press, Cambridge
Granger CW (1969) Investigating causal relations by econometric models and cross-spectral methods. Econometrica 37(3):424–438
Hoover KD (2001) Causality in macroeconomics. Cambridge University Press, Cambridge
Kevin, D. H. (2008). Causality in Economics and Econometrics. The New Palgrave Dictionary of Economics, 2, 1–13.
Huntington-Klein N (2021) The effect: an introduction to research design and causality. Chapman and Hall/CRC, Boca Raton
Karnizova L, Li JC (2014) Economic policy uncertainty, financial markets and probability of us recessions. Econ Lett 125(2):261–265
Klößner S, Sekkel R (2014) International spillovers of policy uncertainty. Econ Lett 124(3):508–512
Krol R (2014) Economic policy uncertainty and exchange rate volatility. Int Financ 17(2):241–256
Liu L, Zhang T (2015) Economic policy uncertainty and stock market volatility. Financ Res Lett 15:99–105
Ludvigson SC, Ma S, Ng S (2021) Uncertainty and business cycles: exogenous impulse or endogenous response? Am Econ J Macroecon 13(4):369–410
Ma Y, Wang Z, He F (2020) How do economic policy uncertainties affect stock market volatility? Evidence from g7 countries. Int J Financ Econ 27:2303–2325
Pástor Ľ, Veronesi P (2012) Uncertainty about government policy and stock prices. J Financ 67(4):1219–1264
Pearl J (1995) Causal diagrams for empirical research. Biometrika 82(4):669–688
Pearl J (2009) Causality: models, reasoning and inference, 2nd edn. Cambridge University Press, Cambridge
Peters J, Janzing D, Schölkopf B (2017) Elements of causal inference. The MIT Press, Cambridge
Poon S-H, Granger CW (2003) Forecasting volatility in financial markets: a review. J Econ Lit 41(2):478–539
Schwert GW (1989) Why does stock market volatility change over time? J Financ 44(5):1115–53
Spirtes P, Glymour CN, Scheines R, Heckerman D (2000) Causation, prediction, and search. MIT Press, Cambridge
Author information
Authors and Affiliations
Corresponding author
Ethics declarations
Conflict of interest
The views expressed in this paper do not necessarily reflect those of the Oesterreichische Nationalbank or the Eurosystem.
Additional information
Publisher's Note
Springer Nature remains neutral with regard to jurisdictional claims in published maps and institutional affiliations.
Appendix
Appendix
Table 4 shows the results of univariate and multivariate Jarque–Bera tests for normality of the residuals of the reduced form VAR(1) model, \(z_m = \Phi _1z_{m-1} + v_m\) implied by the SVAR(1) model.
Rights and permissions
Springer Nature or its licensor (e.g. a society or other partner) holds exclusive rights to this article under a publishing agreement with the author(s) or other rightsholder(s); author self-archiving of the accepted manuscript version of this article is solely governed by the terms of such publishing agreement and applicable law.
About this article
Cite this article
Raunig, B. Using causal graphs to test for the direction of instantaneous causality between economic policy uncertainty and stock market volatility. Empir Econ 65, 1579–1598 (2023). https://doi.org/10.1007/s00181-023-02409-7
Received:
Accepted:
Published:
Issue Date:
DOI: https://doi.org/10.1007/s00181-023-02409-7