Foreign Shocks Research Articles

How Important are Foreign Shocks in Small Open Economy? The Case of Slovakia

In this paper, we provide evidence on the nature and the relative importance of domestic and foreign shocks in Slovak economy based on block-restriction vector autoregression model in 1999-2007. We document well-functioning monetary transmission mechanism in Slovakia. Subject to various sensitivity checks, we find that contractionary monetary policy shock has a temporary negative effect on the degree of economic activity and price level. We find that using output gap instead of GDP alleviates the price puzzle. In general, prices are driven mainly by foreign factors and the European Central Bank monetary policy shock on Slovak prices is more powerful than that of the National Bank of Slovakia. Slovak central bank interest rate policy seems to follow the ECB's interest rates. On the other hand, spectacular Slovak economic growth is primarily driven by domestic factors suggesting the positive role of recently undertaken Slovak economic reforms.

Does a Monetary Union Protect again Foreign Shocks? An Assessment of Latin American Integration using a Bayesian VAR

This paper analyses the monetary consequences of the Latin-American trade integration process. We consider a sample of five countries - Argentina, Brazil, Chile, Mexico and Uruguay - spanning the period 1991-2007. The main question raised pertains to the feasibility of a monetary union between L. A. economies. To this end, we study whether this set of countries is characterized by business cycle synchronization with the occurrence of common shocks, a strong similarity in the adjustment process and the convergence of policy responses. We focus especially our attention on two points. First, we try to determine to what extent international disturbances influence the domestic business cycles through trade and/or financial channels. Second, we analyze the impact of the adoption of different exchange rate regimes on the countries' responses to shocks. All these features are the main issues in the literature relative to regional integration and OCA process.

US shocks and global exchange rate configurations

Many academics and observers emphasize that a sharp US dollar depreciation is inevitable for returning the burgeoning US current account deficit to more sustainable levels. How may such a US dollar adjustment occur, and what may it imply for global exchange rate configurations? The paper focuses on the role of US-specific economic shocks in the adjustment process, and finds that such US shocks have historically exerted a remarkably heterogeneous effect across currencies. It shows that this heterogeneity is not only due to policy choices of inflexible exchange rate regimes or to monetary policy, but to an important extent is explained by market forces, in particular the degree of financial integration – foremost in portfolio investment – though not by trade. This helps explain why it has been in particular the euro, and its predecessor currencies, as well as other European currencies that have contributed the bulk to the adjustment of the US dollar effective exchange rate over the past 25 years, while other flexible currencies have been much less responsive to US shocks. The results suggest that currency flexibility is a necessary but not a sufficient condition for achieving a more balanced contribution across currencies to an adjustment of global exchange rate configurations. Exchange rates are responsive to foreign shocks only to the extent that market mechanisms are in place that make this transmission work, which requires in particular that countries have well-developed financial markets and are financially integrated. These findings have implications for an unwinding of global imbalances, and for monetary policy choices and financial market policies in emerging market economies. —Marcel Fratzscher

Does Openness to Trade Make Countries More Vulnerable to Sudden Stops, or Less? Using Gravity to Establish Causality

Openness to trade is one factor that has been identified as determining whether a country is prone to sudden stops in capital inflow, currency crashes, or severe recessions. Some believe that openness raises vulnerability to foreign shocks, while others believe that it makes adjustment to crises less painful. Several authors have offered empirical evidence that having a large tradable sector reduces the contraction necessary to adjust to a given cut-off in funding. This would help explain lower vulnerability to crises in Asia than in Latin America. Such studies may, however, be subject to the problem that trade is endogenous. We use the gravity instrument for trade openness, which is constructed from geographical determinants of bilateral trade. We find that openness indeed makes countries less vulnerable, both to severe sudden stops and currency crashes, and that the relationship is even stronger when correcting for the endogeneity of trade.

Foreign Versus Domestic Factors as Sources of Macroeconomic Fluctuations in Hong Kong

This paper uses a semi-structural vector autoregression approach to estimate the relative importance of domestic and foreign shocks as sources of macroeconomic fluctuations in Hong Kong since the adoption of the currency board. We find that external factors are clearly dominant in the medium to long run. In view of the highly open nature of the Hong Kong economy and the linkages implied by the currency board arrangement, it is perhaps not unexpected. However, that these factors should account for fifty percent or more of unexpected fluctuations in real GDP and the GDP deflator at shorter horizons of one to two years is more surprising, and it is large in comparisons with other highly open small economies. Even if external shocks are dominant sources of macroeconomic fluctuations, there remain significant short-term influences of domestic variables. For example, in the historical decomposition of the evolution of output growth and inflation we discovered a significant role for domestic factors in the recent recession. Their impact resembles very much those that would be generated by a conventional aggregate supply contraction. A challenge for future research is to identity empirically the exact sources of the domestic shocks.

Contagion or Real Linkages? Some Evidence from China's Emerging Parallel Markets

AbstractThis paper empirically tests the existence of contagion using data on China's five parallel markets with different entry barriers for foreign capital. Taking the 1997 stock market crash as our experiment and using data on A, B and H shares, red chips and American depository receipts, the present paper tests whether these China‐backed market returns respond differently to foreign shocks during the pre‐1997 and post‐1997 crash period. Evidence suggests that the contagion effects are stronger in markets with fewer entry barriers. An important implication of our findings is that countries vulnerable to contagion could be justified to impose some limits on capital flows.

Inflation targeting supported by managed exchange rate

We compare, on a welfare loss basis, possible inflation targeting regimes supported by different exchange rate rules. For model parametrization, we estimate a forward looking monetary policy rule for Trukey. When variable inflation targets are taken into consideration, as opposed to the fixed targets used in prior research that use data from developed countries, forward looking Taylor rules provide a reasonable description of Central Bank behaviour in Turkey. By applying a calibration based on estimated parameters, we compare the loss functions under flexible inflation targeting and strict inflation targeting while taking into consideration the supporting regimes, namely a flexible exchange rate and a managed floating exchange rate. We find that the welfare loss function caused by four simultaneous shocks, namely a foreign interest rate shock, a monetary policy shock, a foreign output shock and a domestic output shock, is minimized under the flexible inflation targeting regime supported by a managed floating exchange rate rule.

Interest Rate Rules and Welfare in Open Economies

This paper analyses the welfare performance of a set of five alternative interest rate rules in an open economy stochastic dynamic general equilibrium model with nominal rigidities. A rule with a lagged interest rate term, high feedback on inflation and low feedback on output is found to yield the highest welfare for a small open economy. This result is robust across different degrees of openness, different sources of home and foreign shocks, alternative foreign monetary rules and different specifications for price setting behaviour. The same rule emerges as both the Nash and cooperative equilibria in a two-country version of the model.

The advantages of introducing an exchange rate target within the statutes of the European Central Bank

With the help of a Keynesian dynamic macro-economic model in an open economy, this paper studies the possible consequences of introducing an exchange rate target within the statutes of the European Central Bank. It appears that such a target would have only slight implications for the mitigation of demand or external supply shocks. In the case of internal negative supply shocks, this scheme could limit the conflict of goals between the monetary and budgetary authorities and reduce the slowdown in economic activity. Nevertheless, the fact that the central bank tends to limit the fluctuations in its interest rates already has the same implications. On the contrary, in the case of positive shocks on interest rates in the rest of the world, an exchange rate target could have its own advantages. Such a scheme could limit the budgetary deficits and the variations in economic activity triggered by foreign shocks.

Information transmission and spillover in currency markets: A generalized variance decomposition analysis

This paper investigates the dynamics in the British Pound (BP), Deutsche Mark (DM), Swiss Franc (SF), and Japanese Yen (JY) futures using Generalized Variance Decomposition analysis over the 1985–2005 period. The results support the interdependence hypothesis against the segregation model with the degree of susceptibility to foreign shocks varying across currencies; internal forces are more dominant for BP and JY, whereas DM and SF are more exposed to external shocks. The results also reveal that SF was tightly linked to the DM before the demise of the latter, whereas it became aligned with the BP afterwards. The inter-currency effects lessened in the post-1987 crash period and then reversed course in the beginning of the new century.

Common shocks, common dynamics, and the international business cycle

This paper proposes an econometric framework to assess the importance of common shocks and common transmission mechanisms in generating international business cycles. Then we show how to decompose the cyclical effects of permanent–transitory shocks into those due to their domestic and those due to foreign components. Our empirical analysis reveals that the business cycles of the US, Japan, Canada are clearly dominated by their domestic components. The Euro area is more sensitive to foreign shocks compared to the other three countries of our analysis.

Common Shocks, Common Dynamics and the International Business Cycle

This paper proposes an econometric framework to assess the importance of common shocks and common transmission mechanisms ingenerating international business cycles. Then we show how to decompose the cyclical effects of permanent-transitory shocks into those due to their domestic and those due to foreign components. Our empirical analysis reveals that the business cycles of the US,Japan,Canada are clearly dominated by their domestic components. The Euro area is more sensitive to foreign shocks compared to the other three countries of our analysis.

Stock Market Linkages Before and After the Asian Financial Crisis: Evidence from Three Greater China Economic Area Stock Markets and the US

We investigate the stock market linkages between the United States and three Greater China Economic Area stock markets — China, Hong Kong, and Taiwan, before and after the 1997 Asian financial crisis. Daily stock market indices from January 1995 to December 2000 are used for the analysis. Results from Granger causality test indicate increased feedback relationships between the markets in the post-crisis period. We also find, from the principal component analysis, fewer common factors affecting stock returns after the crisis, suggesting more harmonious market co-movements after the financial crisis. Additionally, results from a variance decomposition analysis suggest that stock markets are more responsive to foreign shocks after the crisis. This further strengthens the evidence that stock markets become more interrelated after the 1997 Asian financial crisis.

International transmission of inflation among G-7 countries: A data-determined VAR analysis

We investigate the international transmission of inflation among G-7 countries using data-determined vector autoregression analysis, as advocated by Swanson and Granger [Swanson, N., Granger, C., 1997. Impulse response functions based on a causal approach to residual orthogonalization in vector autoregressions. Journal of the American Statistical Association 92, 357–367]. Over the period 1973–2003, we find that unexpected changes in US inflation have large effects on inflation in other countries, although they are not always the dominant international factor. Similarly, shocks to some other countries also have a statistically and economically significant influence on US inflation. Moreover, our evidence indicates that US inflation has become less vulnerable to foreign shocks since the early 1990s, mainly because of the diminished influence from Germany and France.

An Open-Economy DSGE Model of the Euro Area

An open-economy DSGE model for the euro area is presented, with the explicit aim to model the price pass-through for foreign shocks, with a special emphasis on oil price shocks. The model includes a multiple-sector supply side with explicit use of energy as a factor of production and the presence of distribution costs. The model is augmented with an almost symmetric rest of the world and a simpli ed set of equations for energy-exporting countries. Calibration of the model is done suing extensive use of data, including input-output tables. The conclusion is that a modelling of imports as input factors, not only nal-demand goods, may help mapping the structure into the data and provide a more robust analysis of the pass-through.

WAGE-PRICE DYNAMICS AND DEFLATION IN HONG KONG

Abstract. We provide empirical evidence on the dynamics of prices and wages in Hong Kong. The results suggest that the post-1997 deflation can be understood using a conventional macroeconomic framework wherein foreign influences constitute the basic underlying shocks, and adjustment processes in domestic wages and prices determine the details of the transmission mechanism. We find that the decline in local nominal prices owes much to declining prices of imported intermediate goods. The negative output gap and increase in unemployment during the deflation period also have their origin in foreign shocks, but the domestic wage adjustment process is an important contributing factor.

Currency substitution in Asian countries

The objective of this study is to investigate the importance of the U.S. dollar to six Asian economies, as a substitute or complement to domestic monetary assets. Towards this goal, the Morishima elasticity of substitution is estimated between domestic currency, the U.S. dollar and time and savings deposits at commercial banks in Indonesia, Japan, Korea, Malaysia, Singapore and Thailand over the period 1977 to 1996. We observe that the domestic currency and the U.S. dollar are Morishima substitutes in every country, and the demand for the U.S. dollar relative to the domestic currency appears to respond more to a change in the opportunity cost of holding domestic money (exchange rate depreciation) than the opportunity cost of holding the U.S. dollar (the domestic interest rate). A higher degree of currency substitution is found in Japan, Korea, and Singapore than the rest of the countries. Moreover, there is an indication of an increasing degree of currency substitution over time in every country except for Malaysia. Currency substitution creates a channel for the transmission of exogenous monetary disturbances from abroad. The vulnerability of money demand in the face of foreign shocks increases pressure on the monetary authorities to accommodate these shocks under a pegged exchange rate system. The cost of this accommodation proved to be unsustainable during the Asian crisis as foreign reserves were drawn down. Hence, there is the need to build up an adequate foreign reserves position to accommodate the degree of currency substitution and dollarization.

Financial Crisis and Intertemporal Linkages Across the ASEAN-5 Stock Markets

The stock indices of five ASEAN countries, namely, Singapore, Malaysia, Indonesia, Thailand and the Philippines have experienced a structural change after mid-1997 due to the Asian financial crisis, and another shift slightly more than a year later when the markets rebounded. Contemporaneous correlation in stock returns is the strongest and Indonesia leads the movements of the other indices during the crisis. The relative influence of foreign shocks is much more felt during the crisis, as seen in the stronger and longer horizon of responses of all the markets. The stock indices are cointegrated before, but not during the crisis. Price feedbacks between the larger markets of Singapore, Malaysia and Indonesia that existed before the crisis disappear once the crisis is over. Short-run linkages of Malaysia with the other markets have weakened after the crisis. With an increase in the degree of exogeneity of its stock market, contemporaneous co-movements with the other markets have reduced and the causal relationships no longer exist.

Welfare Implications of Joining a Common Currency

This paper examines the welfare implications of a country joining a currency union as opposed to operating in a flexible exchange rate regime. At the country level, the suboptimal response to domestic and foreign shocks and the inability of setting inflation at the desired level may be offset by a positive impact on potential output. We show that for entry to be welfare enhancing, the potential output gain must be the larger, the smaller the country, the larger the difference between the standard deviation of supply shocks across the participating countries, the smaller the correlation of countries’ supply shocks and the larger the variance of real exchange rate shocks. JEL Classification: E52, E58, F33, F40

Swedish Postwar Business Cycles: Generated Abroad or at Home?

AbstractThe relative importance of foreign and domestic shocks for the Swedish postwar business cycle is examined in a neoclassical stochastic growth model of a small open economy. Since recent research has shown that fiscal policy shocks may be important for business cycles, I extend previous work in the literature by allowing for stochastic fiscal policy. It is found that the introduction of fiscal policy improves the empirical fit of the model, although not significantly so when hours worked are detrended with the HP filter. The results suggest that domestic shocks are more important than foreign shocks for output fluctuations. Among the domestic shocks, innovations in fiscal policy seem to have been more important than technology shocks during this period. Foreign shocks are very important for fluctuations in the real exchange rate and the current account.