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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.


Can Structural Small Open Economy Models Account for the Influence of Foreign Disturbances?
Last Updated: 11/20/09

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.