Nonlinear Causal Relationship Between Economic Policy Uncertainty and Macroeconomic Variables in Selected Emerging Market Economies

Abstract

This paper sought to close the gap on the inconsistent findings on the causal relationship between uncertainty and business cycles. We investigate the causal relationship between economic policy uncertainty (EPU) and business cycles in six emerging market economies, during the period January 1999 to December 2018. We significantly contribute to the literature by adopting a robust nonlinear causality test and the maximal overlap discrete wavelet transform that transforms the series into multilevel wavelet and scaling coefficients. The empirical findings are thus presented in short-, medium-, and long-term dynamics, which correspond to investors’ different time horizons. We further introduce new variables which significantly alter our understanding of the inconsistent findings between EPU and business cycles. We record a handful of evidence to prove that EPU is both a cause and effect of business cycle fluctuations, except for India that records a one-way causality from business cycles to EPU. These findings are significant because they provide investors and policymakers with information on the causal relationship between EPU and business cycles over time and across frequencies, which can be used to improve policy formulations and investment strategies across time horizons. Furthermore, the findings aid in explaining the inconsistent findings in the literature.