Regional Shocks and the Performance of the Uruguayan Economy, 1974-1997

The performance of the Uruguayan economy has been influenced not only by world economic conditions but also by shocks coming from two large neighboring countries. This paper investigates the impact of regional shocks - defined as external shocks originated in Argentina and Brazil - on key Uruguayan variables. We first develop a simple model to understand the transmission of regional shocks. Three key features separate our setup from the conventional "dependent economy" model: (i) we introduce a regional demand for what would otherwise be a nontradable good (because of this particular feature, it is called a regional good); (ii) the price of the regional good is sticky in the short run and, (iii) unemployment caused by real wage rigidities is allowed. Although both fixed and floating exchange rate systems are analyzed, most of the attention is given to the study of the former regime. If the central bank of the small country fixes the exchange rate, the economy reacts to a regional boom by running an initial trade surplus, and an excess of demand in the market of the regional good arises. The model predicts inflation during the adjustment period. A trade deficit may also be observed during this period. If the shock is permanent, the new long run equilibrium will be one with an appreciated exchange rate and a different composition of trade. Under reasonable assumptions, the model also predicts a raise in employment and real output. In the empirical part of the paper we measure the importance of regional shocks, and we study the adjustment of output and domestic prices measured in terms of U.S. dollar to foreign shocks. The estimation of near-VAR models that comprise domestic, regional, and rest of the world variables provides evidence that regional instability was the main source of external disturbances faced by the Uruguayan economy during the period 1974.I-1997.I. Historical decomposition suggests that the importance of regional shocks varied significantly throughout the period. We fmd that a favorable regional shock induced an output boom, caused inflation, and led to a real appreciation of the Uruguayan currency. These fmdings are consistent with the theoretical model. The chief underlying sources of regional instability are found to be the swings in the economic policies in those countries. Several channels through which regional shocks were transmitted to the Uruguayan economy are identified.