The Predictive Power of Economic Policy Uncertainty for Exchange Rate Volatility: Evidence From Multiple Economies

Abstract

This paper evaluates the in-sample and out-of-sample forecasting performance of EPU vis-à-vis other widely used macroeconomic variables for volatility in exchange rate variability. Our findings, based on both in-sample and out-of-sample forecasting across a range of economies, indicate that the differential of the EPU between any two nations is persistently one step ahead of alternative macroeconomic predictors. Monte Carlo simulations and mechanism analysis indicate that a greater differential of the EPU is negatively correlated with bilateral trade, on the one hand, and positively with bilateral foreign exchange trading activities, on the other hand. The findings further indicate that EPU is a formidable predictor of both short-run and long-run exchange rate volatility once the endogeneity problem has been addressed, along with using multiple proxies. These results have important implications for studies about the causes of exchange rate fluctuations and enlighten policymakers and market participants on managing foreign exchange risks.