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

  • Alejandro Justiniano
  • Bruce Preston

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 percent 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.

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Paper provided by Federal Reserve Bank of Chicago in its series Working Paper Series with number WP-09-19.

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Date of creation: 2009
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Handle: RePEc:fip:fedhwp:wp-09-19
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