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Article Excerpt
UNDERSTANDING THE INTERNATIONAL transmission of structural shocks is important for identifying the best policy response to international developments. In a world economy that has experienced a steady increase in goods, capital, and financial markets integration, the international dimension of the transmission mechanism has become an essential ingredient of the policy discussion.
A long-standing empirical literature, pioneered by Eichenbaum and Evans (1995) and Grilli and Roubini (1995), has used small-scale vector autoregressions (VARs) to identify the dynamic effects of foreign and domestic monetary policy shocks. The research program on the empirics of the international transmission mechanism has delivered a few open-economy anomalies such as the exchange rate and the forward discount puzzles.
Together with other anomalies such as the price and liquidity puzzles, already apparent in closed economy studies, these facts pose a serious challenge to our ability of isolating correctly a monetary shock. In an effort to improve identification, a number of contributions have proposed alternative schemes, ranging from nonrecursive to sign restrictions, which, however, have had mixed success in rationalizing the puzzles. A sample of important contributions include Cushman and Zha (1997), Kim and Roubini (2000), Faust and Rogers (2003), and Scholl and Uhlig (2005).
In this paper we approach this identification issue from another perspective. In particular, we examine the role played by the limited information set used in previous studies in generating various puzzles. Central banks across the world monitor (and possibly respond to) a far wider information set than typically assumed in small-scale VARs. To the extent that the additional information processed by central banks are not reflected in small-scale VARs, the measurement of policy innovations is likely to be contaminated: what appears to the econometrician to be a policy shock is, in fact, the response of the monetary authorities to the extra information not included in the VAR. This identification problem associated with omitted variables is well recognized in econometrics. In the empirical literature on the international transmission mechanism, the issue can only be more severe as the number of variables (and countries) that are relevant for policy analysis increases rapidly when moving from closed to open-economy investigations.
In this paper, we attempt to solve the limited information problem associated with small-scale empirical models by proposing an open-economy factor augmented VAR (FAVAR). We extract international and UK-specific common components from a large panel of data covering 17 industrialized countries and around 600 price, activity, and money indicators. We use the FAVAR to model the interaction between the UK economy and the rest of the world, which we treat as the "foreign" block.
The contribution of the paper is twofold. First, we quantify the dynamic effects on a wide variety of UK aggregate and disaggregate variables of a common shock to short-term interest rates and to real activity in the foreign block. Second, we assess the extent to which the open-economy anomalies documented in earlier empirical contributions can be explained by the limited information in small-scale VARs.
The main results are as follows. In response to a deviation from the systematic component of monetary policy across the rest of the world, the nominal exchange rate peaks within 1 year, implying that we find scant evidence of delayed overshooting. An unanticipated monetary expansion in the rest of the world exerts its maximum impact on real house price inflation, investment, GDP growth, and consumption growth after 1 year, on wages after 2 years, and on CPI and GDP deflator inflation during the third year. A positive international supply shock makes the sectoral distribution of UK consumption deflators negatively skewed. A domestic monetary policy shock in the UK is associated with little evidence for the exchange rate and liquidity puzzles; furthermore, the forward discount and the price anomalies are very modest and short-lived.
This work extends the FAVAR approach developed by Bernanke, Boivin, and Eliasz (2005) to the open economy. Other contributions using large panel of international data include Miniane and Rogers (2007), Lagana and Mountford (2005), Ruffer and Stracca (2006), and Sousa and Zaghini (2007). These papers, however, focus on the role of capital controls and excess global liquidity. Boivin and Giannoni's (Forthcoming) analysis is most similar in spirit to our paper: they use a FAVAR to gauge the evolution of the impact of the international factors on the U.S. economy. The two analyses, however, differ in a number of dimensions, including the structure of the FAVAR model, the identification strategy, the estimation method and the country analyzed in the empirical application.
An interesting alternative to the FAVAR approach is the global VAR model introduced by Dees et al. (2007). The global VAR incorporates an explicit model for all countries in the sample, which are linked via a set of observed and unobserved international factors. The global VAR is particularly convenient when the goal is to examine the impact of shocks that originate in specific foreign countries (rather than the rest of the world as in our FAVAR). On the other hand, the FAVAR is particularly convenient when the goal is to estimate the dynamic responses of a large number of home variables to foreign shocks. Furthermore, the FAVAR allows one to incorporate a large amount of information in the model in a very simple manner.
The paper is organized as follows. Section 1 presents a FAVAR model for open economies, discusses the identification, and briefly describes the wide set of international variables used in the empirical investigation. Section 2 reports the dynamic effects of an unexpected fall in world interest rates, an unexpected increase in world activities, and a positive international supply shock on selected UK variables. The exchange rate and forward discount puzzles are revisited in Section 3 where we present the impulse response functions to a UK monetary policy shock. The appendices provide details on the data and the identification.
1. AN OPEN-ECONOMY FAVAR
A large empirical literature has investigated the international transmission of monetary and nonmonetary shocks using small-scale structural VAR. The correct identification of the systematic component of monetary policy has been widely recognized as crucial to trace out the dynamic effects of the shocks of interest.
Several contributions have proposed alternative identification structures including, among others, the recursive schemes in Grilli and Roubini (1995), Eichenbaum and Evans (1995), and Faust and Rogers (2003); the nonrecursive schemes in Cushman and Zha (1997), Kim and Roubini (2000), and Kim (2001); and the sign restrictions in Canova (2005) and Scholl and Uhlig (2005).
Despite the differences in identification, these contributions share two important features. First, the VARs are based on a few variables, rarely exceeding 14 at the very end of the spectrum. Second, the empirical results show evidence of open-economy anomalies, and it is difficult, for instance, to solve the delayed exchange rate overshooting and the forward discount puzzles simultaneously.
In analogy to the closed-economy contribution by Bernanke, Boivin, and Eliasz (2005), we ask whether the use of a wide information set, relative to earlier studies, can improve our understanding of the international transmission of policy and nonpolicy shocks and shed new lights on long lasting puzzles in international macroeconomics.
This section proposes an open-economy FAVAR model in which a large international panel of macroeconomic variables is used to identify an unanticipated fall in the interest rates of the rest of the world, an unanticipated expansion in world real activity, and a domestic monetary policy shock. (1)
1.1 The Empirical Model
The model consists of two blocks, one for the UK, which is named "domestic," and one for the rest of the industrialized world, which is named "foreign" and it is ordered first. The information about the UK and rest of the industrialized world are summarized by K unobserved factors, [F.sub.t] = [[F.sup.*.sub.t] [F.sup.uk.sub.t]]' where asterisks denote the foreign economies. The UK short-term interest, [R.sub.t], is the only observable factor, and together with the unobserved common components it forms a dynamic system that evolves according to the following transition equation:
[MATHEMATICAL EXPRESSION NOT REPRODUCIBLE IN ASCII], (1)
where B(L) is a conformable lag polynomial of finite order p, and [u.sub.t] = [[OMEGA].sup.1/2] [e.sub.t] with the structural disturbances [e.sub.t] ~ N (O, I' and [OMEGA] = [A.sub.0]([A.sub.0])'.
The unobserved factors are extracted by a...
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