Economic policy uncertainty and dollar-pound exchange rate return volatility

Abstract

The extent to which economic policy uncertainty (EPU) amplifies exchange rate volatility has been an important research question for at least a decade. Previous research has investigated this relationship using monthly data, concluding that EPU imparts an effect on exchange rate volatility either contemporaneously, or with a one month lag. The use of monthly frequency, however, may not provide an accurate causal interpretation, and may even compromise the accuracy of the estimates if the natural cycles of EPU are shorter than a month. To address this econometric concern I construct uncertainty measures at a daily frequency, and estimate a GARCH model using daily USD/British pound returns. The evidence indicates that EPU contributes to exchange rate volatility much more quickly than monthly data can detect. Using a regression technique for separating EPU from non-policy economic uncertainty, I find that non-policy market uncertainty increases volatility more than EPU does.