Analysis of the Relationship between Exchange Rate and Economic Policy Uncertainty Index by Fourier Approach: The Case of BRIC Countries

Abstract

Economic uncertainties create changes in many areas from production to consumption, from savings to investment, from national policies to international regulations and make themselves felt immediately. The clarity and decisiveness of economic policies have a direct impact on financial markets. As a matter of fact, the increase in global uncertainties raises the risk premiums of fragile countries and shapes the spending and savings of economic agents. In fact, an increase in economic policy uncertainty directly affects the national currencies of countries, especially trading partners. Considering that exchange rate fluctuations generally reflect the degree of risk, exchange rates become more volatile during periods of increased uncertainty about economic policies. In this respect, understanding the volatility of exchange rates will make it easier for policymakers to control risks and uncertainties and develop policies accordingly. In this study, the effect of economic policy uncertainty index on exchange rate volatility for BRIC countries is investigated using monthly data for the period 1997:1-2022:8. The economic policy uncertainty index used in the study is compiled from the Economic Policy Uncertainty Index (EPU Index). Empirical analyses are conducted using Fourier-based time series analysis techniques. In this context, first of all, the unit root properties of the series were investigated with the Fourier ADF unit root test developed by Enders and Lee (2012). The cointegration relationship between the series was examined through the Fourier Shin cointegration test developed by Tsong et al (2016). For the estimation of long-term cointegration coefficients, DOLS, FMOLS and CCR estimators including Fourier functions were used. The findings show that there is a long-run cointegration relationship between the exchange rate and economic policy uncertainty in the countries studied. When we look at the cointegration coefficients, economic policy uncertainty affects the exchange rate positively in Brazil and Russia, but negatively in China. In India, the economic policy uncertainty coefficient was found to be statistically insignificant.