Fragility and the effect of international uncertainty shocks

Abstract

When economic systems are fragile, even modest shocks, for example a shock to international capital movements, can have strong negative effects on key macroeconomic fundamentals. This paper proposes a large-scale Bayesian vector autoregression with factor stochastic volatility to investigate the macroeconomic consequences of international uncertainty shocks in G7 countries and shows that uncertainty increases fragility. The factor structure enables us to identify an international uncertainty shock by assuming that it is the joint volatility process that determines the dynamics of the variance–covariance matrix of the common factors. To allow for first and second moment shocks we, moreover, assume that the uncertainty factor enters the VAR equation as an additional regressor. Our findings suggest that an international uncertainty shock has negative effects across all economies and variables under consideration, leading to strong declines in output, prices, exports, interest rates and equity prices. The precise degree of fragility varies across countries; a simple correlation exercise suggests that structural differences may be partially responsible for the observed differences.