Economic policy uncertainty and stock market liquidity: Evidence from G7 countries

Abstract

In the aftermath of the 2007–2008 global financial crisis, there were heightened concerns among the market participants and policymakers on the potential adverse effects of economic policies on stock market liquidity. This paper examines the causality and co-movement between economic policy uncertainties and stock market liquidity using monthly data from G7 countries. Our empirical analysis considers wavelet coherence and wavelet phase angle tests. Linear and nonlinear causality test results suggest that a causal relationship exists between economic policy uncertainty and stock market liquidity. Moreover, stock market illiquidity varies with the uncertainty but in the same direction while liquidity co-moves in the opposite direction. In times of economic turmoil or crises, the relationship between policy uncertainty and illiquidity becomes stronger, and illiquidity leads economic policy uncertainty. Overall, our findings indicate that the leading indicator property of (il)liquidity is useful for providing economic information and thereby to manage market conditions and investor expectations.