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Decoding the macroeconomic impact of uncertainty

india, indian economy, macroeconomy

The period of uncertainty (after an economic shock or the fear of occurrence of the event, rather than the occurrence itself) can have a substantial impact on various economic variables by altering the decision-making behaviour of individuals at the macro or micro level. The economic shock here refers to any economic policy (monetary or fiscal), regulation changes, any decision taken by the central bank, policymakers or the government, or any unexpected economic development.

Although there has been significant research on the impact of uncertainty on economic variables, it was not until the recent financial crisis that it began to be widely researched and quantified. Several research papers have provided evidence on how increased uncertainty has made a noticeable impact on real activity in various countries. This is of particular importance to policymakers. For any policy decision to be effective, it becomes relevant that the potential benefits are rightfully understood by the group of individuals for whom the policy is designed for or the nation. Any uncertainty caused by the news of a policy decision might make it difficult to implement effectively and/or negate the positive outcomes to an extent. An example is the recent demonetisation and the implementation of GST, which created huge uncertainty and impacted the Indian economy.

It has been well-documented how uncertainty, regarding financial crises, has impacted the growth path of various countries globally, including India. For example, uncertainty explained part of the collapse in global economic activity in 2008-09 (Stock and Watson 2012) and of the sluggish ensuing economic recovery (IMF 2013).

During 2012-18 (till September 2018), did uncertainty play any role in influencing the movement of the multiple economic variables? We looked at the impact of economic policy uncertainty (EPU) shocks on Indian macroeconomic variables such as index of industrial production (IIP), retail inflation, short-term money market rates, stock market, the rupee, and imports using Impulse Response Function (IRF). As a measure of uncertainty, we have considered the EPU index developed by Baker et al (2013) a news-based economic policy related uncertainty index for major economies around the world, including India. The accompanying graphic plots the uncertainty index and the various shocks that impacted the economy during this period.

It was found that the duration of the response in industrial production against the uncertainty shock lasted for about eight months before returning to long-term equilibrium level. Uncertainty caused significant changes in the initial few months, and a large impact in the third month. An impulse in uncertainty at time zero had a negligible impact on retail inflation or CPI; it impacted the most between first and second months, but the effects of the shock completely dissipated around the fourth month. It has also been found that uncertainty explained only 0.67% of the variation in CPI in the first month. An impulse in uncertainty on 91-day treasury bills at time zero had a maximum negative impact in the second month and became positive in the fourth, but started to taper off from then onwards.

Interestingly, for the stock market, an impulse in uncertainty at time zero had a maximum positive impact in the second month, which then started to taper off from the fourth month. One standard deviation shock in uncertainty causes a significant change in the rupee for three consecutive periods and it took seven months for the rupee to return to its equilibrium level. Further, one standard deviation shock in uncertainty caused a significant impact on imports during the first month and the impact of the shock lasted for six months before returning to equilibrium.

The author is lead economist, Dun and Bradstreet India