POLICY UNCERTAINTY AND FOREIGN EXCHANGE RATES: THE DCC-GARCH MODEL OF THE US / JAPANESE FOREIGN EXCHANGE RATE

Abstract

Since the breakdown of the Bretton Woods system in the 1970s, the US / Japan foreign exchange rate has been largely influenced by policy changes in the United States and Japan. This study applies the multivariate dynamic conditional correlation (DCC) – generalized autoregressive conditional heteroscedasticity (GARCH) models to analyze the time-varying effects of policy uncertainty, measured by the economic policy uncertainty (EPU) index of Baker et al. (2013, 2016), on the US / Japan foreign exchange rate. Using the EPU index as a proxy variable, it shows that the dynamic conditional correlations between policy uncertainty and the exchange rate are not time-invariant, but even sign-changing in the sample period. The analysis also empirically examined what drives the evolution of the time-varying correlations. The driving force of the correlations is, however, mostly attributed to unknown random factors. 

Data:
Received: 16 Sep 2016
Revised: 28 Oct 2016
Accepted: 6 Dec 2016
Published: 20 Dec 2016