How are policy uncertainty, real economy, and financial sector connected?

Frequent economic policy adjustments increase economic policy uncertainty. Recent studies show that policy uncertainty has contractionary effects on real investment. We conduct a disaggregated tripartite inquiry into policy uncertainty-real economy-financial sector nexus by analyzing inter- and intra-variable shock transmissions. Using monthly US data from January 1985 to June 2022, we find cross-variable shock transmissions account for 48% of total shock spillovers. The impulse response analysis shows that policy uncertainty shocks temporarily amplify financial sector variables but have varying contractionary effects on real sector variables. The network analysis identifies credit as the primary financial channel for transmitting policy uncertainty shocks to the real economy. Due to their net shock transmission roles, policy uncertainty and financial sector variables, particularly credit, and leverage, exert time-varying destabilizing effects on the real sector. Therefore, policymakers should pay close attention to these variables to minimize their adverse feedback loops and stabilize the real sector. •Cross-variable shock transmissions account for 48% of the total shock spillovers.•Uncertainty shocks amplify financial variables but dampen real economy variables.•Credit is the main channel of transmitting uncertainty shocks to the real economy.•The intensity and direction of shock transmissions are dynamic and nonlinear.•Leverage is most destabilizing in a real-financial-uncertainty system of variables.