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Can structural small open-economy models account for the influence of foreign disturbances?

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  • Justiniano, Alejandro
  • Preston, Bruce

Abstract

This paper demonstrates that an estimated, structural, small open-economy model of the Canadian economy cannot account for the substantial influence of foreign-sourced disturbances identified in numerous reduced-form studies. The benchmark model assumes uncorrelated shocks across countries and implies that U.S. shocks account for less than 3% of the variability observed in several Canadian series, at all forecast horizons. Accordingly, model-implied cross-correlation functions between Canada and U.S. are essentially zero. Both findings are at odds with the data. A specification that assumes correlated cross-country shocks partially resolves this discrepancy, but still falls well short of matching reduced-form evidence. One central difficulty resides in the model's inability to account for comovement without generating counter factual implications for the real exchange rate, the terms of trade and Canadian inflation.

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  • Justiniano, Alejandro & Preston, Bruce, 2010. "Can structural small open-economy models account for the influence of foreign disturbances?," Journal of International Economics, Elsevier, vol. 81(1), pages 61-74, May.
  • Handle: RePEc:eee:inecon:v:81:y:2010:i:1:p:61-74
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    More about this item

    Keywords

    Small open economy models International comovement Structural estimation Bayesian analysis Exchange rate disconnect;

    JEL classification:

    • F41 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - Open Economy Macroeconomics

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