The Impact of US Monetary Policy and External Shocks to Small Open Economies

Abstract

The world has been highly connected and integrated that one country cannot think of surviving alone. What happened during the 97 Asian Financial Crisis and how the 08 Global Financial Crisis developed truly showed us that one countrys problem was that of every other country. Lately, the shockwaves coming from the other side of the world are getting much more often and much faster. If it were relatively small and open, the impact generated by external shocks like the two major global crises should be big. Then, do the external shocks really matter to these small open economies? Is the impact still effective in the long term? This paper is mainly designed to find out to what extent the monetary policy of the US and fluctuations of other external factors, in this paper, the oil price can affect small open economies. So, I select 5 countries out of the OECD member list that share a similar economic scale and similar economic level and these countries are classified as small open economies. The vector regressive model has been developed through the research on the monetary policy and its effect over the domestic economy. However, until today, little have the development been made on research of the small open economies and the impact of external shocks. Some scholars such as Cushman and Zha have made some achievement to develop the most proper tool to estimate the external shocks over the small open economies and this methodology is called a structural vector autoregressive model (SVAR model). Due to its effectiveness to find out the effect of the external shocks on the small open economies, I will use the structural VAR model. For the significance of factors whose fluctuations are caused by the external shocks on key economic indicators, I take the variance decomposition as well. Using the structural VAR model, it finds that by the negative external shocks, 5 countries experienced negative innovations of exchange rate, positive innovation, but quick decrease of exports, positive innovation but drastic fall of output, the rise of producer price index, positive innovation of interest rate, and lastly, positive monetary aggregates. Results of the variance decomposition show that exchange rates and export do affect on the changes of key economic factors which are producer price index, industrial productivity, and aggregate money which represent inflation, GDP and liquidity.