Identifying aggregate supply and demand shocks in small open economies

This paper separates macroeconomic shocks into external and domestic aggregate demand and supply shocks in European Union's post-transition countries. Small open economies are typically very responsive to external shocks. The standard decomposition into aggregate demand and supply shocks covers up important information on the sources of business cycle fluctuations. Using a Bayesian SVAR model with combined sign and block exogeneity restrictions, we separately estimate external and domestic aggregate supply and demand shocks for GDP growth and inflation. We find that domestic shocks were a dominant source of fluctuations during the transition period in Croatia from 1992 to 2000. However, external shocks increased their importance with the trade and financial sector liberalization after 2000, becoming the dominant source of fluctuations with the Global financial crisis in 2008. In the short run, fluctuations are best explained by domestic shocks in 9 out of 11 analyzed countries, especially domestic supply shocks. However, in the medium run, fluctuations are dominantly explained by external aggregate demand shocks in 8 out of 11 countries. We argue that common sources of fluctuations in the medium run are beneficial for common monetary policy in the Eurozone.