Uncertainty and exchange rate volatility: Evidence from Mexico

This paper analyzes the effect of different types of uncertainty by implementing an in-depth case study of Mexican peso US dollar exchange rate volatility. The paper exploits unique data from the Banco de México's Survey of Professional Forecasters to construct four distinct, direct knightian uncertainty measures, and two macro surprise measures. These measures, as well as text-based and financial data based measures common in the literature, are used to test for distinct uncertainty effects. Exchange rate volatility during 1999–2018 is regressed onto uncertainty measures capturing both domestic and international, economic and political uncertainty. The main results show higher knightian uncertainty leads to higher exchange rate volatility. While both domestic and international measures affect exchange rate volatility, international uncertainty measures based on text and financial data (the global EPU and the VIX) and our novel survey-based knightian measure of domestic political uncertainty dominate. The paper also presents evidence of an amplifying effect of domestic economic uncertainty on exchange rate volatility during recession periods. The results are robust to different exchange rate volatility measures and different specifications.