Modelling International Linkages for Large Open Economies: US and Euro Area

Empirical modelling of the international linkages between the Euro Area and the US requires an open economy specification. This paper proposes and implements a structural VECM framework which imposes long run and short run cross-economy restrictions based on theoretically motivated restrictions and empirically supported dominance assumptions. The SVECM distinguishes between permanent and temporary shocks in a system where one cross-economy cointegrating relationship links output levels. In addition, the short run dynamics incorporate both contemporaneous interactions and feedbacks between the two economies. Importantly, greater empirical coherence is obtained by allowing for more direct inflationary effects between the two economies than considered in other recent analyses. Estimated using data from 1983Q1 to 2007Q4, the results demonstrate the cross-country impact of shocks. Although US shocks generally produce stronger effects, nevertheless some shocks originating in the Euro Area have significant effects on the US, particularly for inflation and interest rates.