International spillovers of US monetary and fiscal policies on small open economies

Abstract

This thesis focuses on the spillover effects of US monetary and fiscal policies on some of its main trading partners. The first chapter examines the cross-border macroeconomic effects of US monetary policy shocks on Canada and Mexico. To do this, we depart from the standard two-country VAR models routinely used in the literature by adopting a proxy VAR approach. In particular, we employ the first-stage model averaging method to construct an optimal instrument for US monetary policy shocks. The main finding of this chapter is that US monetary policy shocks have a significant impact on Canada’s macroeconomic variables, but not so for those of Mexico. The second chapter provides a theoretical model of the spillover effects of monetary policies based on various competing price regimes. It investigates the impact of the US monetary policy on its two neighbours, Canada and Mexico, under two different pricing regimes: Producer Currency Pricing (PCP); and Dominant Currency Pricing (DCP). We use a New Keynesian DSGE model to explain the transmission channels of monetary policy under various pricing systems. We find that in a Likelihood race, the model with DCP outperforms the model with PCP. Furthermore, by analysing the variance decomposition of business cycle fluctuations, the dominant role of foreign monetary shock in overall fluctuations is observed. The third chapter focuses on the second wing of the domestic policy which is fiscal policy. Since the recent financial crisis of 2007/08, the spillover effects of fiscal policies have become increasingly important in the wake of the zero interest rate lower bound. Using SVARs with external instruments and data on macroeconomics variables from the UK and Canada, we find that shocks to the US fiscal policy cause the trade balance in the UK to increase, while they cause the Canadian dollar to appreciate against the US dollar.