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Abstract

This research contributes to a better understanding of how and when political events affect the economy. We conclude that instead of looking at the aftermath of events, one should focus on audience reaction to the narrative about a political event. We develop a new methodology to identify the moment when audiences are immersed in the political narrative, and find that when the audience is paying attention to it, markets behave differently. We measure the costs associated with political narrative and discover that they are immense and not temporary, as indicated by rising costs of borrowing, lower valuations, drops in FDI, and insurance costs surging. We argue that the higher volatility caused by the narrative is the outcome of imprecise political communication and "cheap talk," which triggers uncertainty, which then dominates the markets' behavior. Market participants, when faced with the uncertainty caused by a new political event, initially cannot quantify risk, and herd behavior is driven by a "run to safety." This is reflected in previously unknown correlations in stock returns, which we conceptualize in a new risk factor and use it to explain volatility in the returns of individual stocks and broad indices. Using the case of the narrative about sanctions imposed on Russia in 2014, and a theoretical game theory model, we show that under certain circumstances, significant costs imposed on the target in the early stages of conflict might decrease the chances of early compliance. We propose a list of possible policy applications with the potential to increase the efficiency of economic sanctions. These can be applied to political communication to contain the markets' reactions, and preserve the power to increase pressure in the later stages of the conflict.

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