Political economic uncertainty in a small & open economy: the case of Uruguay

It has been well documented by the macroeconomic literature the negative effects of economic policy instability on economic uncertainty and investment decisions. In changing environments, agents prefer to delay investment decisions in fixed capital, ultimately leading to the depression of economic activity. Uruguay, as a small and open economy of South America, has historically faced strong external shocks. Therefore, not only local instability of economic policy affects, also international and regional ones affect macroeconomic volatility and growth. With the objective of quantifying and analyzing uncertainty and volatility in the Uruguayan economy, we built an uncertainty composite index adapting the methodology proposed by Baker, Bloom & Davis (2015). In order to address how local and global economic policy uncertainty affects the volatility of the Uruguayan economy we include in the composite index, local and external uncertainty indicators. We represent local uncertainty by agent's divergence on expectations about the future of the exchange rate. In order to account for both, regional and global shocks, we include uncertainty indicators of the relevant economic-world for Uruguay. Empirical strategy is based on a combination of statistical methods of principal components analysis and time series techniques. We test two alternative indexes, both of them starting in January 2004. Our results show that although both uncertainty indexes seem to be good predictors of the volatility for the whole period, they losses predictability power in the last years.