The World Is Not Enough! Small Open Economies and Regional Dependence

• Published date: 01 January 2016
• DOI: http://doi.org/10.1111/sjoe.12126
• Date: 01 January 2016

Scand. J. of Economics 118(1), 168–195, 2016

DOI: 10.1111/sjoe.12126

The World Is Not Enough! Small Open

Economies and Regional Dependence∗

Knut Are Aastveit

Norges Bank, NO-0107 Oslo, Norway

Knut-Are.Aastveit@norges-bank.no

Hilde C. Bjørnland

BI Norwegian Business School, NO-0484 Oslo, Norway

hilde.c.bjornland@bi.no

Leif Anders Thorsrud

BI Norwegian Business School, NO-0484 Oslo, Norway

leif.a.thorsrud@bi.no

Abstract

In this paper, we explicitly introduce regional factors into a global dynamic factor model.

We combine new open economy factor models (emphasizing global shocks) with the recent

findings of regional importance in the business cycle synchronization literature. The analysis

is applied to a large panel of domestic data for four small open economies. We find that

global and regional shocks explain roughly 30 and 20 percent, respectively, of the business

cycle variation in all countries. While global shocks have most impact on trade variables,

regional shocks explain a relatively large share of the variation in cost variables.

Keywords: Business cycle synchronization; factor model; globalization; international trans-

mission; regionalism

JEL classification:C32; E32; F41

I. Introduction

The most recent decades have been termed an era of globalization. Total

trade as a share of world GDP has increased significantly, while the liber-

alization of economic policies and financial markets has boosted financial

integration. This has led to rapid economic growth in many regions of

the world, beginning with the US and Europe, and now extending through

much of Asia, parts of Africa, and South America.

∗We thank Richard Burdekin, Efrem Castelnuovo, Marcelle Chauvet, Sandra Eickmeier,

Francesco Ravazzolo, Terje Skjerpen, Simon van Norden, and two anonymous referees, as

well as conference and seminar participants at CEF San Francisco, the Federal Reserve Bank

of Cleveland, the European Central Bank, University of California, Riverside, and University

of Padova for valuable comments. The views expressed in this paper are those of the authors

and do not necessarily reflect the views of Norges Bank.

CThe editors of The Scandinavian Journal of Economics 2015.

K. A. Aastveit, H. C. Bjørnland, and L. A. Thorsrud 169

A long-standing body of literature has investigated the patterns of glob-

alization and regionalism, and their impacts on business cycle synchro-

nization, inflation, and interest rates.1While studies such as Kose et al.

(2003) seem to confirm that world factors were indeed sufficient to de-

scribe the evolution of domestic business cycles, studies covering more

recent periods find support for an increase in the role of regional factors.

In particular, Clark and Shin (2000), Stock and Watson (2005), Moneta and

R¨

uffer (2009), and Mumtaz et al. (2011) find that regional factors play a

prominent role in explaining the evolution of the business cycle in different

countries and regions, especially in North America, Europe, and Asia.

It is important for policy institutions in small open economies to un-

derstand how international developments affect the domestic economy. The

business cycle synchronization literature referred to above does not study

this, as these studies abstract from the issue of identifying the shocks.

Moreover, models that analyze the transmission of international shocks to

the domestic economy largely ignore the issues of globalization and region-

alism. For instance, small-scale structural vector autoregressions (VARs) of

the open economy, such as Eichenbaum and Evans (1995) and Grilli and

Roubini (1996), typically use a two-country model to account for foreign

influence, while open economy factor models, such as Mumtaz and Surico

(2009), Boivin and Giannoni (2010), and Liu et al. (2011), identify shocks

to common global factors but do not discriminate between regional and

world factors.2

In this paper, we combine the new open economy factor model studies

with the recent findings in the business cycle synchronization literature,

and explicitly include both regional and world factors in a dynamic factor

model (DFM). More precisely, we extend the global factor model frame-

work proposed by Mumtaz and Surico (2009) to include regional factors.

To do so, we estimate a three-block DFM model with separate world, re-

gional, and domestic blocks. The analysis is applied to four representative

small open (advanced) economies: Canada, New Zealand, Norway, and the

UK. The countries are located across the world, in different geographical

regions.

In addition to including regional factors, our DFM set-up differs from

Mumtaz and Surico (2009) in two other important respects. First, we allow

the dynamics of all the domestic variables to be a linear combination of

both foreign (world and regional) and domestic factors. This implies that

both domestic and foreign shocks can affect the domestic variables on

1See, for example, Kose et al. (2003, 2012) and Baxter and Kouparitsas (2005) on business

cycle synchronization, and Mumtaz and Surico (2012), Monacelli and Sala (2009), and

Ciccarelli and Mojon (2010) on the co-movement of inflation rates.

2See also Eickmeier (2007) and Eickmeier et al. (2011) on the transmission of US shocks

to individual countries.

CThe editors of The Scandinavian Journal of Economics 2015.