Uncertainty and the US economy: An investigation of the economic effects of economic policy uncertainty shocks originating in the US and Europe

This paper investigates the effect of economic policy uncertainty shocks originating in the US and four major European economies (France, Germany, Italy and the UK) on US employment and industrial production. Using Baker et al. (2016)’s newspaper-based EPU indices to quantify economic policy uncertainty, and monthly macroeconomic data from January 1987 to December 2015, vector autoregressive models and smooth transition vector autoregressive models are estimated to model the dynamic relationship between economic policy uncertainty and macroeconomic variables. Estimates of dynamic effects of uncertainty shocks are obtained by constructing (generalised) impulse response functions. In order to recover orthogonal shocks, this paper uses external instruments in a new instrumental variable approach alongside standard Cholesky decompositions. External instruments are constructed by using a dynamic factor model for EPU indices from multiple countries to estimate latent common and country-specific uncertainty factors. By replicating the results of Baker et al. (2016), it is confirmed that domestic economic policy uncertainty shocks can have negative effects on the employment level and the industrial production level in the US. Extending the analysis, it is found that domestic economic policy uncertainty shocks are also followed by decreases in the growth rates of employment and industrial production during both recessions and expansions. Further, it is found that while there is significant evidence of spillovers of European economic policy uncertainty into US economic policy uncertainty, these are very small in magnitude. When considering direct economic effects of increased European economic policy uncertainty, only shocks to French economic policy uncertainty are found to be followed by decreases in US economic growth, while shocks to economic policy uncertainty in Germany, Italy and the UK trigger no significant responses.