Tracking Economic Policy Uncertainty through the Relative Sentiment Shift

Abstract

We examine the causal dynamic relationship between economic policy uncertainty and economic activities, using a Local Projection model with an external instrument. Based on the psychological theory of conviction narratives, we construct a Relative Sentiment Shift (RSS) index and use it as an instrumental variable that captures exogenous variations in economic policy uncertainty. Our empirical results using the US data from January 1996 to December 2019 suggest that an increase in economic policy uncertainty induces recessionary pressures in the economy: reductions in production and employment, a sharp stock market downturn, and a constrained financial market.