The Impulse Response of Domestic and Foreign Interest Rate in Output, Price, Exchange Rate Model, a Deconstructed Derivation and Economic Calibration of Vector Error Correction Model

Abstract

How to assess external shocks, whether they are inflationary shocks or interest rate shocks without warning, is crucial to construct smooth and predictable financial market. The purpose of this paper is to analyze the short-run and long-run effects of shocks on an economy under chaotic conditions of uncertainty using the Vector Error Correction Model (VECM). A comprehensive and detailed derivation process is presented for VECM and reveals the dynamics of interest rates and inflation in the face of external shocks, through Cholesky ordering and impulse response decomposition. With a constraint, the VECM model is also used to derive its two applications in well-known theoretical fields, the Fisher model and the uncovered interest rate parity (UIP) theory.