Economic policy uncertainty and cost stickiness

Abstract

We examine the effect of aggregate economic policy uncertainty (EPU; Baker et al., 2016) on firms’ asymmetric cost reaction to sales changes (cost stickiness). We find that cost stickiness decreases with EPU in the United States (US) after we control for the positive relationship between cost stickiness and election years (Lee et al., 2020). This result is consistent with managers revising down their expectations of future demand and adjustment costs during high-EPU years, causing them to drastically cut operating costs. The stickiness of cost of goods sold and number of employees are particularly sensitive to EPU. The duration of EPU appears to be an important factor in explaining this negative relationship. EPU directly affects firms that depend on government spending and belong to highly regulated industries. EPU also indirectly affect all firms via its impacts on the aggregate economy and funding costs. We use an international sample to confirm the result and to explore the institutional factors that moderate the effect of EPU on cost stickiness.