The macro-financial impact of economic policy uncertainty in Latin America
Summary
Focus
Emerging market economies (EMEs) generally exhibit higher levels of domestic uncertainty than advanced economies (AEs), and heightened uncertainty can jeopardise macro-financial stability. Uncertainty can lead to the postponement of investment and consumer decisions, as well as volatility in financial markets, ultimately affecting economic activity and price levels. From a regional perspective, Latin America is no exception, as both global and domestic uncertainty pressures create a challenging environment. Distinguishing between the effects of domestic and foreign sources of uncertainty is particularly difficult for EMEs, as they are highly exposed to both.
Contribution
This study measures the macroeconomic impact of domestic uncertainty in EMEs, using Latin America as a case study. To isolate the effect of domestic sources of uncertainty, given the region's high dependency on global developments, we adjust the domestic economic policy uncertainty measure to exclude global sources of uncertainty. We assess the average impact of domestic uncertainty shocks in four Latin American countries over the past 20 years. Additionally, we go beyond the average effect and analyse the heterogeneous effects of domestic uncertainty in Latin America by examining downside and upside risks of tail events. Finally, we refine our findings by studying the transmission of uncertainty through two proposed channels: the real channel and the financial channel.
Findings
We find that domestic uncertainty shocks cause significant macroeconomic disruptions, leading to a contraction in output and a rise in inflation, akin to a supply shock. These effects are transmitted through a financial channel in the short term – via higher risk premia, increased equity market volatility and exchange rate depreciations – and through a real channel in the medium term – via declines in growth expectations and consumer and business confidence. Our analysis further reveals that uncertainty shocks are most damaging when the economy is weak or financial conditions are tight, whereas stronger economies are better able to absorb such shocks.
Abstract
This paper investigates the impact of domestic economic policy uncertainty (EPU) on macroeconomic and financial variables in emerging market economies, focusing on Latin America. Using a panel dataset for Brazil, Chile, Colombia and Mexico from 2005 to early 2025, we find that domestic EPU shocks cause significant macroeconomic disruptions, leading to a contraction in output and a rise in inflation, akin to a supply shock. These effects are transmitted through a financial channel in the short term, via higher risk premia, increased equity market volatility and exchange rate depreciations, and through a real channel in the medium term, via declines in growth expectations and consumer and business confidence. Our analysis further reveals that EPU shocks are most damaging when the economy is weak or financial conditions are tight, while stronger economies are better able to absorb such shocks.
JEL Classification: C33, D80, E23, E31
Keywords: macroeconomy, uncertainty, economic policy uncertainty, Latin America
