Measuring the Effects of Dollar Appreciation on Asia: A Favar Approach

Abstract

Exchange rate shocks have mixed effects on economic activity in both theory and empirical VAR models. In this paper, we extend the empirical literature by considering the implications of a positive shock to the U.S. dollar in a factor-augmented vector autoregression (FAVAR) model for the U.S. and three large Asian economies: Korea, Japan and China. The FAVAR framework allows us to represent a country's aggregate economic activity by a latent factor, generated from a broad set of underlying observable economic indicators. To control for global conditions, we also include in the FAVAR a “global conditions index,” which is another latent factor generated from the economic indicators of major trading partners. We find that a dollar appreciation shock reduces economic activity and inflation not only for the U.S. economy, but also for all three Asian economies. This result, which is robust to a number of alternative specifications, suggests that in spite of their disparate economic structures and policy regimes, the dollar appreciation shock affects the Asian economies primarily through its impact on U.S. aggregate demand; and this demand channel dominates the expenditure-switching channel that affects a country's export competitiveness.