Business Cycles through International Shocks: A Structural Investigation

One sentence summary: Through structural Bayesian estimations of an open-economy DSGE model on 16 countries, it is found that international shocks explain around 70% of output fluctuations.

Non-technical Summary

The devastating effects of the 2008 crisis on world output have one more time triggered the research on business cycles. In a global world, from an accounting point of view, crises are contiguous through either international finance (i.e., nominal) shocks or international trade (i.e., real) shocks. By also considering real and nominal domestic shocks, this paper is an attempt to decompose the sources of volatility in output into four possible shocks: (i) international finance shocks through foreign interest rates, (ii) international trade shocks through transportation/trade costs, (iii) technology shocks through productivity, (iv) monetary policy shocks through central bank behavior. An open-economy dynamic-stochastic-general-equilibrium (DSGE) model is structurally estimated for 16 countries using state-of-the-art Bayesian estimation techniques.

Regarding country-specific details, United Kingdom (respectively, Singapore) has the lowest (respectively, highest) degree of price stickiness among 16 countries. The weight given to inflation in the Taylor rule is highest (respectively, lowest) for Japan (respectively, Indonesia), while the weight given to output is highest (respectively, lowest) for United Kingdom (respectively, South Africa). The highest (respectively, lowest) degree of interest-rate smoothing belongs to Japan (respectively, South Africa). When it comes to shocks, on average, Indonesia is exposed to the highest degrees of technology and monetary policy shocks, Costa Rica is exposed to the highest degree of foreign interest rate shocks, and Singapore is exposed to the highest degree of international trade cost shocks.

In order to gauge the importance of the individual shocks on the output volatility, we compute variance decompositions of output for all 16 countries. Instead of representing country-specific variance decomposition tables, we investigate how the variance decomposition of output changes across countries with respect to country-specific characteristics. The results show evidence for significantly higher contributions of international shocks (i.e., international trade costs and foreign interest rate shocks) relative to national shocks (i.e., technology and monetary policy shocks). In particular, significant effects of international finance shocks on output volatility (about 50%, on average) are followed by the effects of international trade costs (about 20%, on average), monetary policy (about 20%, on average), and technology (about 10%, on average).

The effects of international trade costs and technology (respectively, foreign interest rate) shocks on output volatility are higher (respectively, lower) in countries with lower price stickiness; this is mostly because changing domestic prices reflect international trade costs and technology changes through substitution effect between domestic and foreign goods.?

The effects of international trade costs and technology (respectively, foreign interest rate and monetary policy) shocks on output volatility are higher in countries with lower discount factors. This is mostly because impatient countries are affected immediately from such costs through substitution effect between domestic and foreign goods.?

The weight given to output in the Taylor rule seems to be an indicator, where the effects of international trade costs and technology (respectively, foreign interest rate) shocks on output volatility are higher (respectively, lower) in countries with higher output considerations in the Taylor rule. This reflects the additional distortionary effect of higher interest rates, again, through substitution effect between domestic and foreign goods.?

Interest-rate smoothing seems to have a positive (respectively, negative) contribution on the effects of international trade costs, technology, and monetary policy (respectively, foreign interest rate) shocks on the output volatility. This is mostly because of an income effect that lacks the balancing contribution of interest-rates through international trade costs in the IS curve which leads output exposed to more international trade costs and technology shocks.?

The published paper is available at Economics Letters .