Does Economic Policy Uncertainty Move the Market? An Econometric Analysis of Stock Market Volatility and Uncertainty Indices

Abstract

This paper examines the relationship between stock market volatility and economic policy uncertainties in financial, economic and political realms. We select eight policy related uncertainty indices developed by Baker, Bloom and Davis (2016) and subject them to causality tests to determine their utility in forecasting stock market volatility, as measured by volatility index (VIX). Of the eight indices, five are found to possess predictive causality. We then develop a distributed lag (DL) model to assess the explanatory powers of each of the indices. Based on the DL model, we run impulse response analyses for each variable to observe the stock market’s reaction over time to policy uncertainty shocks. The econometric analyses of this paper reveal how market volatility is an increasing function of the product of economic uncertainty. In a less technical way, our findings show that the stock market is an informative gauge to understand the cost of policy uncertainty.    

JEL classifications: G12; E6

Keywords: Stock Market Volatility, Economic Policy Uncertainty, Policy Indices, VIX