Dynamic Connectedness among Business Cycle, Financial Cycle, and Policy Uncertainty Index in India

Kundan Kumar; Rajendra Narayan Paramanik

doi:10.47654/v26y2023i4p127-146

Authors

Kundan Kumar Department of Humanities and Social Sciences, Indian Institute of Technology Patna, Patna, India Corresponding Author
Rajendra Narayan Paramanik Department of Humanities and Social Sciences, Indian Institute of Technology Patna, Patna, India Author

DOI:

https://doi.org/10.47654/v26y2023i4p127-146

Keywords:

Business cycle, Financial Cycle, Uncertainty, TVP-VAR, India

Abstract

Purpose: Pervasive impact of uncertainty necessitates relooking at the traditional empirical approaches to gauge the nexus between the real economy and the financial market, especially after the 2008 financial meltdown. The recent pandemic and ongoing geo-political tension across the globe further emphasized the need for augmentation of the existing analytical framework to address the prime importance and influence of uncertainty on the real economy and financial market. This is why, in this paper, we empirically attempted to calculate the connectedness among the business cycle, financial cycle, and economic policy uncertainty in India. The major contribution of this work can be attributed to the TVP VAR model-based empirical investigation of time-varying connectedness among the aforementioned three variables for the Indian economy from January 1997 to May 2022. Unlike erstwhile works, the paper assesses the net transmitter and receiver of shocks in the multivariate framework too.

Design/methodology/approach: To estimate the dynamic connectedness among business cycle, financial cycle, and economic policy uncertainty, this paper integrates Diebold and Yilmaz's (2014) connectedness technique with Antonakakis and Gabauer's (2017) TVP-VAR methodology.

Findings: We found that the business cycle and financial cycle are the primary receivers of shocks whereas policy uncertainty is the primary transmitter of shocks.

Originality/value: To the best of our knowledge, this is the first empirical attempt to use such a technique in the Indian business cycle literature.

Practical implications: The findings of the paper suggest the need to augment the existing policy framework by incorporating the economic uncertainty component. A stable economic environment is congenial to promote investment and garner consumers’ confidence to boost growth in developing nations like India.

References

Aikman, D., Haldane, A. G., & Nelson, B. D. (2015). Curbing the credit cycle. The Economic Journal, 125(585), 1072-1109. https://doi.org/10.1111/ecoj.12113

Antonakakis, N., Chatziantoniou, I., & Filis, G. (2013). Dynamic co-movements of stock market returns, implied volatility and policy uncertainty. Economics Letters, 120(1), 87-92. https://doi.org/10.1016/j.econlet.2013.04.004

Antonakakis, N., Breitenlechner, M., & Scharler, J. (2015). Business cycle and financial cycle spillovers in the G7 countries. The Quarterly Review of Economics and Finance, 58, 154-162. https://doi.org/10.1016/j.qref.2015.03.002

Antonakakis, N., & Gabauer, D. (2017). Refined measures of dynamic connectedness based on TVP-VAR. Technical Report. Munich: University library of Munich. https://mpra.ub.uni-muenchen.de/78282/

Anusha (2015). Credit and growth cycles in India and US: Investigation in the frequency domain [Paper presentation]. 11th ISI Annual Conference on Economic Growth and Development. https://www.isid.ac.in/~epu/acegd2015/papers/Anusha.pdf

Aor, R. L., Salisu, A. A., & Okpe, I. J. (2021). A comparative assessment of the global effects of US monetary and fiscal policy uncertainty shocks. Advances in Decision Sciences, 25(4), 89-114. https://doi.org/10.47654/v25y2021i4p89-114

Aor, R. L., Salisu, A. A., & Okpe, I. J. (2021). The Effects of US monetary policy uncertainty shock on international equity markets. Annals of Financial Economics, 16(04), 1-14. https://doi.org/10.1142/S2010495221500184

Aye, G. C. (2021). Effects of fiscal and monetary policy uncertainty on economic activity in South Africa. Advances in Decision Sciences, 25(1), 167-187. https://doi.org/10.47654/v25y2021i1p167-187

Baker, S. R., Bloom, N., & Davis, S. J. (2016). Measuring economic policy uncertainty. The Quarterly Journal of Economics, 131(4), 1593-1636. https://doi.org/10.1093/qje/qjw024

Balcilar, M., Gupta, R., & Segnon, M. (2016). The role of economic policy uncertainty in predicting US recessions: A mixed-frequency Markov-switching vector autoregressive approach. Economics, 10(1). http://dx.doi.org/10.5018/economics-ejournal.ja.2016-27

Bernanke, B. S. (1983). Irreversibility, uncertainty, and cyclical investment. The Quarterly Journal of Economics, 98(1), 85-106.

Bloom, N., Bond, S., & Van Reenen, J. (2007). Uncertainty and investment dynamics. The Review of Economic Studies, 74(2), 391-415. https://doi.org/10.1111/j.1467-937X.2007.00426.x

Bloom, N. (2009). The impact of uncertainty shocks. Econometrica, 77(3), 623-685. https://doi.org/10.3982/ECTA6248

Bloom, N. (2014). Fluctuations in uncertainty. Journal of Economic Perspectives, 28(2), 153-76. DOI: 10.1257/jep.28.2.153

Bonciani, D., & Oh, J. J. (2019). The long-run effects of uncertainty shocks. https://ssrn.com/abstract=3400834

Burns A. F., & Mitchell W. C. (1946). Measuring business cycles. National Bureau of Economic Research.

Caldara, D., Fuentes-Albero, C., Gilchrist, S., & Zakrajšek, E. (2016). The macroeconomic impact of financial and uncertainty shocks. European Economic Review, 88, 185-207. https://doi.org/10.1016/j.euroecorev.2016.02.020

Castelnuovo, E., Lim, G., & Pellegrino, G. (2017). A short review of the recent literature on uncertainty. Australian Economic Review, 50(1), 68-78. https://doi.org/10.1111/1467-8462.12210

Cesa-Bianchi, A., Pesaran, M. H., & Rebucci, A. (2020). Uncertainty and economic activity: A multicountry perspective. The Review of Financial Studies, 33(8), 3393-3445. https://doi.org/10.1093/rfs/hhz098

Christiano, L. J., & Fitzgerald, T. J. (2003). The band pass filter. International Economic Review, 44(2), 435–465. https://doi.org/10.1111/1468-2354.t01-1-00076

Claessens, S., Kose, M. A., & Terrones, M. E. (2012). How do business and financial cycles interact?. Journal of International economics, 87(1), 178-190. https://doi.org/10.1016/j.jinteco.2011.11.008

Clance, M., Gozgor, G., Gupta, R., & Lau, C. K. M. (2021). The relationship between economic policy uncertainty and corporate tax rates. Annals of Financial Economics, 16(01), 2150002. https://doi.org/10.1142/S2010495221500020

Colombo, V. (2013). Economic policy uncertainty in the US: Does it matter for the Euro area?. Economics Letters, 121(1), 39-42. https://doi.org/10.1016/j.econlet.2013.06.024

Diebold, F. X., & Yilmaz, K. (2009). Measuring financial asset return and volatility spillovers, with application to global equity markets. The Economic Journal, 119(534), 158-171. https://doi.org/10.1111/j.1468-0297.2008.02208.x

Diebold, F. X., & Yilmaz, K. (2012). Better to give than to receive: Predictive directional measurement of volatility spillovers. International Journal of Forecasting, 28(1), 57-66. 10.1016/j.ijforecast.2011.02.006

Diebold, F. X., & Yilmaz, K. (2013). Measuring the dynamics of global business cycle connectedness. https://doi.org/10.1093/acprof:oso/9780199683666.003.0005

Diebold, F. X., & Yılmaz, K. (2014). On the network topology of variance decompositions: Measuring the connectedness of financial firms. Journal of Econometrics, 182(1), 119-134. https://doi.org/10.1016/j.jeconom.2014.04.012

Drehmann, M., Borio, C. E., & Tsatsaronis, K. (2012). Characterising the financial cycle: Don’t lose sight of the medium term!. https://ssrn.com/abstract=2084835

Favero, C., & Giavazzi, F. (2008). Should the Euro area be run as a closed economy?. American Economic Review, 98(2), 138-45. DOI: 10.1257/aer.98.2.138

Jawadi, F., Ameur, H. B., Bigou, S., & Flageollet, A. (2022). Does the Real Business Cycle Help Forecast the Financial Cycle?. Computational Economics, 60(4), 1529-1546. https://doi.org/10.1007/s10614-021-10193-8

Knell, M. (2015). Schumpeter, Minsky and the financial instability hypothesis. Journal of Evolutionary Economics, 25(1), 293-310. https://doi.org/10.1007/s00191-014-0370-8

Knight, F. H. (1921). Risk, Uncertainty and Profit. Boston, MA: Houghton Mifflin Co. http://www.econlib.org/library/Knight/knRUP.html

Koop, G., Pesaran, M. H., & Potter, S. M. (1996). Impulse response analysis in nonlinear multivariate models. Journal of Econometrics, 74(1), 119-147. https://doi.org/10.1016/0304-4076(95)01753-4

Li, X. L., Yan, J., & Wei, X. (2021). Dynamic connectedness among monetary policy cycle, financial cycle and business cycle in China. Economic Analysis and Policy, 69, 640-652. https://doi.org/10.1016/j.eap.2021.01.014

Minsky, H. P. (1977). The financial instability hypothesis: An interpretation of Keynes and an alternative to “standard” theory. Challenge, 20(1), 20-27. https://doi.org/10.1080/05775132.1977.11470296

Mulligan, R. F. (2013). New evidence on the structure of production: Real and Austrian business cycle theory and the financial instability hypothesis. Journal of Economic Behavior & Organization, 86, 67-77. https://doi.org/10.1016/j.jebo.2012.12.027

Nyawo, S. T., & Van Wyk, R. B. (2018). The impact of policy uncertainty on macro-economy of developed and developing countries. Journal of Economics and Behavioral Studies, 10(1), 33-41. doi:10.22610/jebs.v10i1.2086.

Paramanik, R. N., Bhandari, A., & Kamaiah, B. (2022). Financial cycle, business cycle, and policy uncertainty in India: An empirical investigation. Bulletin of Economic Research, 74(3), 825-837. https://doi.org/10.1111/boer.12320

Pastor, L., & Veronesi, P. (2012). Uncertainty about government policy and stock prices. The Journal of Finance, 67(4), 1219-1264. https://doi.org/10.1111/j.1540-6261.2012.01746.x

Pesaran, H. H., & Shin, Y. (1998). Generalized impulse response analysis in linear multivariate models. Economics Letters, 58(1), 17-29. https://doi.org/10.1016/S0165-1765(97)00214-0

Uluceviz, E., & Yilmaz, K. (2020). Real-financial connectedness in the Swiss economy. Swiss Journal of Economics and Statistics, 156(1), 1-20. https://doi.org/10.1186/s41937-019-0049-z

Yan, C., & Huang, K. X. (2020). Financial cycle and business cycle: An empirical analysis based on the data from the US. Economic Modelling, 93, 693-701. https://doi.org/10.1016/j.econmod.2020.01.018