The Anatomy of Small Open Economy Productivity Trends

We estimate a novel empirical (state-space) model to study the effects of international and domestic technology trend shocks on the UK economy. We jointly identify anticipated and unanticipated domestic and international technological innovations arising from changes in total factor productivity (TFP) and investment specific technology (IST). The long-run restrictions used to jointly identify the structural trends in the data are informed by a standard two-country structural model. Our results point to large and persistent swings in productivity. International non-stationary TFP and IST shocks explain about 30% and 24% of the variance of UK GDP, respectively. UK-specific TFP and IST shocks are somewhat less important, but still a relevant factor. Notably, it is the anticipated components of these international and domestic productivity shocks, rather than their unanticipated counterparts, which account for the bulk of the volatility in the data. We dissect the historical role of different shocks as drivers of UK labor productivity growth. We find that a decline in the contribution of international IST shocks, combined with weak domestic TFP growth, can explain the widely documented slowdown in UK labor productivity after the financial crisis. A standard two-country model implies widely-used restrictions on the relative price of investment which we find to be inconsistent with our empirical evidence that relies on a minimum of structure. We show that a two-sector version of this model with adjustment cost in investment and costly sectoral labor reallocation can capture the empirical dynamics.