Inernaional ransmission of shocks: A ime-varying FAVAR approach o he Open Economy Philip Liu Haroon Mumaz Moneary Analysis Cener for Cenral Banking Sudies Bank of England Bank of England CEF 9 (Sydney) 7 July 9 Absrac A growing lieraure has documened changes o he dynamics of key macroeconomic variables in indusrialized counries and highlighed he possibiliy ha hese variables may reac differenly o srucural shocks over ime. This paper inroduces an empirical model which allows he esimaion of ime-varying response of a large se of domesic variables o foreign money supply, demand and supply shocks. The views expressed in his work are hose of he auhors, and do no necessarily reflec hose of he Bank of England. Email: philip.liu@bankofengland.co.uk and haroon.mumaz@bankofengland.co.uk.
Moivaion Wha we do in he paper: Exends he open economy FAVAR models o allow for ime variaions Examine possible changes o he ransmission of inernaional shocks: foreign moneary policy, demand and supply The model capures he changing co-movemens among he macroeconomic ime series by allowing heir dependence on common facors o evolve over ime Also allows for sochasic volailiy in he innovaion process of he facors Inernaional ransmission of shocks, 7 July 9 Slide /4
More references included in he paper. Inernaional ransmission of shocks, 7 July 9 Slide /4 Liu and Mumaz Why is his ineresing or useful? Undersanding of he inernaional ransmission mechanism is an essenial ingredien for policy discussions Small-scale SVAR sudies ofen encouner many open economy anomalies Differen idenificaion schemes have had mixed successes Bernanke e al. (5) propose using FAVAR for srucural analysis o overcome limied informaion problem helps wih closed economy anomalies Boivin and Giannoni (8), and Mumaz and Surico (8) exend he FAVAR o open economy framework many of he open economy anomalies disappear The grea moderaion lieraure had documened significan fall in inflaion and oupu volailiy
Moreover, deec changes in he domesic ransmission mechanism Fix coefficien model esimaes only ell us he average of he pas Unsaisfacory o simply assume he size and he ransmission of inernaional shocks has no changed over his period Main conribuion of he paper: assess possible changes o he ransmission of world moneary policy, demand and supply shocks on he U.K. economy derive dynamic responses for a wider range of economic indicaors robus idenificaion: large daase and agnosic srucural idenificaion scheme Inernaional ransmission of shocks, 7 July 9 Slide 3/4
The small open economy FAVAR model Transiion equaion: F F UK R = B (L) B (L) B (L) B 3 (L) B 3 (L) B 3 (L) B 33 (L) F F UK R + u () The srucure of B(L) reflecs he small open economy assumpion such ha domesic facors does no impac on world facors, bu no he vice versa; and u = Ω / e, where Ω = A, (A, ). The ime-varying covariance marix of he VAR innovaions, u, can be facored as Var(u ) Ω = A H ( A ) () Inernaional ransmission of shocks, 7 July 9 Slide 4/4
Observaion equaion: X Y X π X R = X UK R Λ Y Λ π Λ R Λ UK Λ R F Y F π F R F UK R + v (3) v = ρ(l)v + ǫ (4) The srucure of Λ marix reflecs he facor idenificaion resricions. Noe:. he facor loading Λ is ime-varying (he naure of co-movemen changes over ), all TV coefficiens are assumed o follow RW. () and (3) are closely relaed o Canova and Ciccarelli s (6) large VAR We assume ha all real aciviy series in he foreign block of he model share a common dynamics and ha such common dynamics is no shared by any oher series in he panel. The domesic facors are no explicily idenified. Inernaional ransmission of shocks, 7 July 9 Slide 5/4
Esimaion - Muli-sep Gibbs sampling In sae-space form: F = B(L)F + e, where e N(, Ω ) and Ω = A ( ) H A (5) X = Λ F + v, where v = ρ(l)v + ǫ and ǫ N(, R) (6) Break he complex problem (sampling from he join poserior disribuion) ino a sequence of racable ones (sampling from he condiional disribuions), see Kim and Nelson (998) and Carer and Kohn (994) Quarerly daa from 974Q o 5Q which span 7 counries and 56 series Inernaional ransmission of shocks, 7 July 9 Slide 6/4
Inernaional co-movemens Figure : Sandardized foreign facors (ligh blue band is he 95% confidence inervals).5.5.5 World real aciviy 98 985 99 995 5.5.5.5 World inflaion 98 985 99 995 5 World ineres rae 4 3 98 985 99 995 5 95% CI Gibbs zero PC Inernaional ransmission of shocks, 7 July 9 Slide 7/4
A sylized view of he ransmission of MP* shock Foreign moneary expansion (R* falls) Appreciaion of serling (Q increases) UK aciviies (depend on ES/IE) Producer currency pricing PPP holds ToT improves as UK expors more expensive and impors are cheaper Expendiure swiching (ES) effec from UK o foreign goods Y* rises while Y falls Beggar-hy-neighbour scenario + Local currency pricing Imperfec ERPT PPP does no hold ToT improves by less because impors are no cheaper (priced in ) Less incenive for UK consumer o buy foreign goods Y* rises while Y may rise Posiive income effec (IE) from lower R* Inernaional ransmission of shocks, 7 July 9 Slide 8/4
An unanicipaed increase in world ineres raes varying IRF 4 Real Aciviy.5..5..5..5..5..5..5.5 99 98.3.35 5 5.3.35 5 5 4.5.5.5 Inflaion..5...5..5..5..5 99 98.3.35 5 5.3.35 5 5 4 World Ineres Rae..8.6.4..8.6.4..8.6.4 99 98. 5 5. 5 5 Inernaional ransmission of shocks, 7 July 9 Slide 9/4
varying IRF 4 Accumulaed response: and 4 NEER.5..5..5..4..4 4 Terms of rade.5.5 98 99 98 99.6 5 5 4 5 5.6 5 5 4 4 5 5 4 4 4 4 3 4 6 8 8 6 4 Impor Prices Trade Balance Expor Prices.8.6.4..5..5.5...3 98 99 98 99 98 99 5 5...4...4.6 5 5 5 5 5 5...4...4.6 4 5 5 4 5 5 4 4 4 5 5 3 5 5 3 Inernaional ransmission of shocks, 7 July 9 Slide /4
Invesmen.3.... varying IRF 98 99.6.5.4.3.. 5 5...4.6.8 4 5 5 4 Accumulaed response: and 4 4 GDP... 99 98.35.3.5..5..5 5 5....3.4.5 5 5 4.5.5.5.5 4 Consumpion.4. 99 98.5.4.3.. 5 5...4.6 5 5 4.5.5.5.5 Inernaional ransmission of shocks, 7 July 9 Slide /4
varying IRF 4 Accumulaed response: and 4 CPI Inflaion.5..5...... 4.5.5..3.3.5 98 99.4 5 5.4 5 5 4 Wages.5.5..5 98 99....3.4.5 5 5....3.4.5 5 5 4.5.5.5 4 GDP Deflaor.5..5..5.3 98 99...3.4.5.6 5 5...3.4.5.6 5 5 4.5.5.5 Inernaional ransmission of shocks, 7 July 9 Slide /4
House Prices FTSE yr Bond Shor erm rae.4....4.6.5.4.3...5 varying IRF 98 99.8.6.4..5 5 5 98 99.5 5 5.8 98 99 98 99.6.4..5 5 5 5 5...4.6.5.5.6.4. 4 5 5 4 5 5 4. 5 5.5.5 4 5 5 4 4 4 4 Accumulaed response: and 4 5 5 6 4 6 4 5 5 4 6 4 6 Inernaional ransmission of shocks, 7 July 9 Slide 3/4
Concluding remarks Our resuls are robus o differen idenificaion scheme, eg: Choleski Key resuls: Evidence of swich from PCP o LCP changes he ransmission of foreign moneary policy shocks subsanially In he period before 99, he U.K. response resembles he classic beggarhy-neighour scenario The mued response of asse prices o he MP* shock in he recen period sugges he recen increase asse prices are aribued o oher shocks Inernaional ransmission of shocks, 7 July 9 Slide 4/4