International effects of the euro area versus U.S. policy uncertainty: A FAVAR approach

Building on the growing evidence on the importance of large data sets for empirical macroeconomic modeling, we estimate a large-scale factor-augmented vector autoregressive (FAVAR) model for 18 Organisation for Economic Co-operation and Development (OECD) member countries. We quantify the global effects of economic policy uncertainty shocks and check whether the signs, the magnitude, and the persistence profile are consistent with the literature on the real and financial sector effects of uncertainty. In that respect, we compare the impacts of a U.S. and a Euro area uncertainty shock. According to our results, an increase in uncertainty has a strong negative impact on economic activity, consumer prices, equity prices, and interest rates. Uncertainty shocks cause deeper recessions in Continental Europe (except Germany) than in Anglo-Saxon countries. This pattern is compatible with the view that continental Europe still suffers from institutions which prevent flexible markets. U.S. uncertainty shocks have a bigger impact than their European counterparts. Uncertainty has an impact not only on that country where the shock originates but also has large cross-border effects. In that respect, Switzerland turns out to be the most affected non-Euro area European country. We also find a high degree of synchronization among the responses of national variables to a (foreign) uncertainty shock, indicating evidence of an international business cycle. With respect to the responses of national long-term interest rates to an uncertainty shock, our results reveal a strong “North-South” divide within the European Economic and Monetary Union (EMU), with rates decreasing less significantly in the South. Another important result is that uncertainty shocks emerging in one region quickly raise uncertainty outside the region of origin which appears to be an important transmission channel of uncertainty.