A Little Less Uncertain about the Relationship between Economic Policy Uncertainty and Economic Activity

Marcelo Aragão and Fabia Carvalho

No 585, Working Papers Series from Central Bank of Brazil, Research Department

Abstract: This paper investigates the effect of uncertainty on the business cycle taking into account the interplay between uncertainty and the drivers of cyclical growth, including fiscal and monetary policy. The results shed light on asymmetries in the transmission of uncertainty to the business cycle associated with the policy stance, crisis period, and country development stage. We apply double filtering estimators on a comprehensive cross-country panel over a sample period that includes two events of extreme global distress and find evidence that not only does the level of uncertainty rise in crisis; but its passthrough to economic activity becomes greater, accentuating the drag of crisis on economic activity. At the onset of the Covid-19 crisis, our estimations show that uncertainty alone contributed to 20% of the drop in global GDP. We also find evidence of asymmetry in the response of economic activity to several of its drivers, including monetary and fiscal policy, as they endogenously interact with uncertainty. Our results reinforce the importance of policies that mitigate uncertainty to break the feedback loop of economic drags and uncertainty.

Date: 2023-10
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