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The Impact of the Global Business Cycle on Small Open Economies: A FAVAR Approach for Canada

  • Garima Vasishtha
  • Philipp Maier

Building on the growing evidence on the importance of large data sets for empirical macroeconomic modeling, we use a factor-augmented VAR (FAVAR) model with more than 260 series for 20 OECD countries to analyze how global developments affect the Canadian economy. We focus on several sources of shocks, including commodity prices, foreign economic activity, and foreign interest rates. We evaluate the impact of each shock on key Canadian macroeconomic variables to provide a comprehensive picture of the effect of international shocks on the Canadian economy. Our findings indicate that Canada is primarily exposed to shocks to foreign activity and to commodity prices. In contrast, the impact of shocks to global interest rates or global inflation is substantially lower. Our findings also expose the different channels through which higher commodity prices impact the Canadian economy: Canada benefits from higher commodity prices through a positive terms of trade shock, but at the same time, higher commodity prices tend to lower global economic activity, hurting demand for Canadian exports.

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Paper provided by Bank of Canada in its series Staff Working Papers with number 11-2.

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Length: 32 pages
Date of creation: 2011
Date of revision:
Handle: RePEc:bca:bocawp:11-2
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  1. Souki, Kaouthar, 2008. "Assessing the effects of U.S. shocks on the Canadian economy using alternative identification methods," The North American Journal of Economics and Finance, Elsevier, vol. 19(2), pages 193-213, August.
  2. Johnson, David R & Schembri, Lawrence L, 1990. "Atheoretical and Structural Approaches to Modelling Canadian-American Macroeconomic Interaction," Empirical Economics, Springer, vol. 15(4), pages 367-82.
  3. Philipp Maier & Brian DePratto, 2008. "The Canadian Dollar and Commodity Prices: Has the Relationship Changed over Time?," Discussion Papers 08-15, Bank of Canada.
  4. Eickmeier, Sandra, 2007. "Business cycle transmission from the US to Germany--A structural factor approach," European Economic Review, Elsevier, vol. 51(3), pages 521-551, April.
  5. Stephane Dees & Filippo di Mauro & M. Hashem Pesaran & L. Vanessa Smith, 2004. "Exploring the International Linkages of the Euro Area: A Global VAR Analysis," IEPR Working Papers 04.6, Institute of Economic Policy Research (IEPR).
  6. Vladimir Klyuev, 2008. "Real Implications of Financial Linkages Between Canada and the United States," IMF Working Papers 08/23, International Monetary Fund.
  7. Sims, Christopher A., 1992. "Interpreting the macroeconomic time series facts : The effects of monetary policy," European Economic Review, Elsevier, vol. 36(5), pages 975-1000, June.
  8. Ben Bernanke, 1990. "The Federal Funds Rate and the Channels of Monetary Transnission," NBER Working Papers 3487, National Bureau of Economic Research, Inc.
  9. Marc Giannoni & Jean Boivin, 2008. "Global Forces and Monetary Policy Effectiveness," 2008 Meeting Papers 1067, Society for Economic Dynamics.
  10. Ben S. Bernanke & Jean Boivin & Piotr Eliasz, 2005. "Measuring the Effects of Monetary Policy: A Factor-Augmented Vector Autoregressive (FAVAR) Approach," The Quarterly Journal of Economics, Oxford University Press, vol. 120(1), pages 387-422.
  11. Haroon Mumtaz & Paolo Surico, 2009. "The Transmission of International Shocks: A Factor-Augmented VAR Approach," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 41(s1), pages 71-100, 02.
  12. Stock, James H & Watson, Mark W, 2002. "Macroeconomic Forecasting Using Diffusion Indexes," Journal of Business & Economic Statistics, American Statistical Association, vol. 20(2), pages 147-62, April.
  13. John Burbidge & Alan Harrison, 1985. "(Innovation) Accounting for the Impact of Fluctuations in U.S. Variables on the Canadian Economy," Canadian Journal of Economics, Canadian Economics Association, vol. 18(4), pages 784-98, November.
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