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On the construction of two-country cointegrated VAR models with an application to the UK and US

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  • Heinlein, Reinhold
  • Krolzig, Hans-Martin

Abstract

In this paper we introduce a cointegrated VAR modelling approach for two-country macro dynamics. In order to tackle the curse of dimensionality resulting from the number of variables in multi-country models, we investigate the applicability of the approach by Aoki (1981) frequently used in economic theory. Aoki showed that for a system of linear differential equations, the assumption of country symmetry allows to decouple the dynamics of country averages and country differences into two autonomous subsystems. While this approach can not be applied straightforwardly to economic time series, we generalize Aoki s approach and demonstrate how it can be utilized for the determination of the long-run properties of the system. Symmetry is rejected for the short-run, thus for the given cointegration vectors the final modelling stage is based on the full two-country system. The econometric modelling approach is then enhanced by a general-to-specific model selection procedure, where the VAR based cointegration analysis is combined with a graph-theoretic search for instantaneous causal relations and an automatic general-to-specific reduction of the vector equilibrium correction model. As an application we build up a macro-econometric two-country model for the UK and the US. The empirical study focusses on the effects of monetary policy on the $/ exchange rate. We find interest rate shocks in the UK cause much stronger exchange rate effects than an unanticipated interest rate change by the Fed.

Suggested Citation

  • Heinlein, Reinhold & Krolzig, Hans-Martin, 2012. "On the construction of two-country cointegrated VAR models with an application to the UK and US," Annual Conference 2012 (Goettingen): New Approaches and Challenges for the Labor Market of the 21st Century 62310, Verein für Socialpolitik / German Economic Association.
  • Handle: RePEc:zbw:vfsc12:62310
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    References listed on IDEAS

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    JEL classification:

    • C22 - Mathematical and Quantitative Methods - - Single Equation Models; Single Variables - - - Time-Series Models; Dynamic Quantile Regressions; Dynamic Treatment Effect Models; Diffusion Processes
    • C32 - Mathematical and Quantitative Methods - - Multiple or Simultaneous Equation Models; Multiple Variables - - - Time-Series Models; Dynamic Quantile Regressions; Dynamic Treatment Effect Models; Diffusion Processes; State Space Models
    • C50 - Mathematical and Quantitative Methods - - Econometric Modeling - - - General

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