Impact of Uncertainty and Exchange Rate Shocks: Theory and Global Empirics

Suah, Jing Lian (2022): Impact of Uncertainty and Exchange Rate Shocks: Theory and Global Empirics. Forthcoming in: Journal of Asian Economics

Abstract

This paper offers two points on the impact of uncertainty and exchange rate shocks. (1) A conceptual model where behavioural frictions --- rational inattentiveness and bounded expectations --- interact with uncertainty, generating aggregate fluctuations. Central banks can target these behavioural frictions to stabilise output and prices. (2) Empirical findings from a panel of advanced and emerging economies. Output and inflation slow in response to uncertainty shocks. Government bond yields moderate and exchange rates depreciate, suggesting within-country and between-country flight-to-safety respectively. Exchange rate appreciation shocks generate similar responses. The Malaysia-specific analysis finds divergent responses in employment and output, likely reflecting compositional effects in more productive tradable and less productive non-tradable sectors.

• Item Type: MPRA Paper
• Language: English
• Keywords: Uncertainty, Rational Inattention, Bounded Rationality, VAR
• Subjects: E - Macroeconomics and Monetary Economics > E0 - General > E00 - General; E - Macroeconomics and Monetary Economics > E0 - General > E03 - Behavioral Macroeconomics

References

[1] Davis, S. J. (2016), ‘An index of global economic policy uncertainty’, Macroeconomic Review, October.

[2] Bloom, N. (2009), ‘The impact of uncertainty shocks’, Econometrica, Vol. 77 (3), pp. 623-685.

[3] Baker, S. R., Bloom, N., and Davis, S. J. (2016), ‘Measuring economic policy uncertainty’, The Quarterly Journal of Economics, Vol. 131 (4), pp. 1593-1636.

[4] Jurado, K., Ludvigson, S. C., and Ng, S. (2015), ‘Measuring uncertainty’, The American Economic Review, Vol. 105 (3), pp. 1177-1216.

[5] Alessandri, P. and Mumtaz, H. (2019), ‘Financial regimes and uncertainty shocks’, Journal of Monetary Economics, Vol. 101, pp. 31-46.

[6] Lugilde, A., Bande, R., and Riveiro, D. (2017), ‘Precautional saving: a review of the theory and the evidence’.

[7] Bloom, N. (2000), ‘The real options effect of uncertainty on investment and labour demand’, The Institute for Fiscal Studies Working Papers, Nov. 2000.

[8] Leduc, S., and Liu, Z. (2016), ‘Uncertainty shocks are aggregate demand shocks’, Journal of Monetary Economics, 82, pp.20-35.

[9] Fajgelbaum, P.D., Schaal, E., and Taschereau-Dumouchel, M. (2017), ‘Uncertainty Traps’, The Quarterly Journal of Economics, pp. 1641-1692.

[10] Kamber, G., Karagedikli, O., Ryan, M., and Vehbi, T. (2016), ‘International spillovers of uncertainty shocks: evidence from a FAVAR’, Centre for Applied Macroeconomic Analysis Working Paper.

[11] Verhoogen, E. (2008), ‘Trade, quality upgrading, and wage inequality in the Mexican manufacturing sector’, The Quarterly Journal of Economics, Vol. 123(2), pp. 489-530.

[12] Cravino, J., and Levchenko A. A. (2017), ‘The distributional consequences of large devaluations’, American Economic Review, Vol. 107(11), pp. 3477-3509.

[13] Saffie, F., Varela, L., and Yi, K. (2020). ‘The micro and macro dynamics of capital flows’, National Bureau of Economic Research (NBER) Working Paper, No. 27371.

[14] Benigno, G., Fornaro, L., and Wolf, M. (2020), ‘The global financial resource curse’, Federal Reserve Bank of New York Staff Reports, No. 915, February 2020.

[15] Sims, C. A. (2003), ‘Implications of rational inattention’, Journal of Monetary Economics, Vol. 50, pp. 665-690.

[16] Ding, S. (2018), ‘Bounded rationality in the rules of price adjustments and the phillips curve’, pp. 1-53.

[17] Jackson, L. E., Kliesen, K. L., and Owyang, M. T. (2019), ‘The nonlinear effects of uncertainty shocks’, Federal Reserve Bank of St. Louis Working Papers, Oct. 2019.

[18] Hamilton, J.D. (1996), ‘This is what happened to the oil price-macroeconomy relationship’, Journal of Monetary Economics, 38, 2, pp. 127-157.

[19] Abrigo, M. R. M., and Love, I. (2016), ‘Estimation of panel vector autoregression in Stata’, The Stata Journal, Vol. 16 (3), pp. 778-804. [20] Dieppe, A., Legrand, R., and van Roye, B. (2016), ‘The BEAR toolbox’, ECB Working Paper, 1934.

[21] Jarocinski, M. (2010). ‘Conditional forecasts and uncertainty about forecast revisions in vector autoregressions’. Economics Letters, 108(3), pp. 257–259.

[22] Baur, D.G. and Lucey, B.M., 2010. Is gold a hedge or a safe haven? An analysis of stocks, bonds and gold. Financial Review, 45(2), pp.217-229.

[23] Ludvigson, S. C., Ma, S., and Ng, S. (Forthcoming), ‘Uncertainty and business cycles: exogenous impulse or endogenous response?’, American Economic Journal: Macroeconomics.

[24] Mankiw, N.G. and Reis, R., 2002. Sticky information versus sticky prices: a proposal to replace the New Keynesian Phillips curve. The Quarterly Journal of Economics, 117(4), pp.1295-1328.

[25] Coibion, O. and Gorodnichenko, Y., 2015. Information rigidity and the expectations formation process: A simple framework and new facts. American Economic Review, 105(8), pp.2644-78.

[26] Andrade, P. and Le Bihan, H., 2013. Inattentive professional forecasters. Journal of Monetary Economics, 60(8), pp.967-982.

[27] Abu Bakar, Z. and Abdul Ghani, N.A. (2019) ‘When the Future Starts Today: Inflation Expectations of Malaysian Households’, Bank Negara Malaysia Annual Report 2018, Chapter 4, pp. 93-105.

[28] Richards, S., and Verstraete, M. (2016), ‘Understanding firms’ inflation expectations using the Bank of Canada’s Business Outlook Survey’ Bank of Canada Staff Working Paper 2016-17.

[29] Kydland, F.E. and Prescott, E.C., 1977. Rules rather than discretion: The inconsistency of optimal plans. Journal of political economy, 85(3), pp.473-491.

[30] Taylor, J. B. (1993), ‘Discretion versus policy rules in practice’, Carnegie-Rochester Conference Series on Public Policy, Vol. 39(1), pp.195-214.

[31] Romer, C. D., and Romer, D. H. (2004), ‘A new measure of monetary shocks: derivation and implications’, The American Economic Review, pp. 1055-1084.

[32] Brainard, W. C. (1967), ‘Uncertainty and the Effectiveness of Policy’, The American Economic Review, 57(2), pp. 441-425.

[33] Baker, S. R., Bloom, N., Davis, S. J., and Wang, X. (2013), ‘Economic policy uncertainty in China’, Working Paper.

[34] Arbatli, E., Davis, S. J., Ito, A., and Miake, N. (forthcoming), ‘Policy uncertainty in Japan’, The Economic Challenges of Japan’s Aging and Shrinking Population, International Monetary Fund.

[35] Canova, F., and Ciccarelli, M. (2006), ‘Estimating multi-country VAR models’, ECB Working Papers, No. 603.

[36] Kamdar, R. (2019), ‘The inattentive consumer: sentiment and expectations’.

[37] Beckmann, J. and Czudaj, R., 2017. Exchange rate expectations and economic policy uncertainty. European Journal of Political Economy, 47, pp.148-162.

[38] Canova, F., and Ciccarelli, M. (2013), ‘Panel vector autoregressive models: a survey’, ECB Working Papers, No. 1507.

[39] Tibshirani, R. (1996), ‘Regression shrinkage and selection via the lasso’, Journal of the Royal Statistical Society. Series B (Methodological), Vol. 58 (1), pp. 267-288.

[40] Ahrens, A., Hansen, C. B., and Schaffer, M. E. (2019), ‘lassopack: model selection and prediction in regularized regression in stata’, IZA Discussion Paper, No. 12081.

[41] Machado, J. A. F., Silva, J. M. C. S. (2019), ‘Quantiles via moments’, Journal of Econometrics, Vol. 213 (1), pp. 145-173.

[42] Adrian, T., Boyarchenko, N., and Giannone, D. (2019), ‘Vulnerable growth’, American Economic Review, Vol. 109 (4), pp. 1263-1289.