Role of External Shocks in Small Open Economy

Abstract

This paper extends the DSGE model of Iacoviello (2005) with housing market and collateral constraints to small-open economy version to see how financial friction affects transmission mechanism of external shocks on small open economy. It constructs a structural quasi-closed economy model which stands for the external world in order to identify foreign structural shocks that affect small open economy. Then it incorporates the model with small open economy version whose measure is negligible compared to the large one. Using data of South Korea and the U.S. after 2000, this paper estimates model parameters with Metropolis-Hastings random walk sampling and compare the cross-correlations and forecasting error variance shares calculated based on the model to the empirical ones and results from Bayesian VAR with lagged block-recursive restriction estimated by Gibbs algorithm by Zha (1999). It turns out that the model is able to replicate forecasting error variance shares that structural shocks from the U.S. have on the cyclical fluctuations of output and interest rates in South Korea. However, the model underestimates the cross-correlation between Korean variables and lagged U.S. ones and highly underestimates the forecasting error share of U.S. shocks in inflation and housing price dynamics. In particular, the model does not reproduce highly positive and persistent co-movement of housing prices across countries and highly positive correlation between U.S. housing price and Korean output, which suggests modelling interdependent capital and housing market across countries is essential for further research.