The effects of economic policy uncertainty on European economies: Evidence from a TVP-FAVAR

Recent events such as the financial and sovereign debt crisis have triggered an increase in European Economic Policy Uncertainty (EPU). We use a TVP-FAVAR model with hierarchical priors on the hyperparameters to investigate the effect of EPU on a wide range of macroeconomic variables for eleven European Monetary Union (EMU) countries. First, we find that EPU shocks are transmitted through various channels, such as the real options-, the precautionary savings- and the financial channel. Second, we are able to distinguish between a group of fragile countries (GIIPScountries) and a group of stable countries (northern countries), where the former are more strongly affected by EPU shocks. Third, while the IRFs for most variables differ only in magnitude and not in sign between groups of countries, responses of long term interest rates to EPU shocks have a different sign across countries. Fourth, we discover that investors and traders react more sensitively than consumers to uncertainty. Fifth, we find that EPU shocks affect monetary policy decisions. Sixth, we provide evidence that the transmission of EPU shocks is quite stable over time. Finally, the increase in EPU can partly be explained by the state of the European economy and should therefore be treated as an endogenous variable.