Understanding the spread of economic shocks in a globalized world is critical to identifying the best policy response to international developments in an individual economy. The authors study the importance of foreign demand, supply, and interest rate shocks on small open economies—for example, the UK economy—and assess how the role of these shocks has changed over time.

Economic shocks and the subsequent policy responses are of great interest to central bankers and asset managers alike. The best policy response to economic shocks depends on an understanding of the transmission mechanism of these shocks.

The authors examine the importance of foreign demand, supply, and interest rate shocks in the UK economy (the “domestic economy”) using a time-varying factor-augmented vector autoregression (FAVAR) model that captures the relationship between 17 industrialized countries and the United Kingdom. The model accounts for any temporal evolution in this relationship.

Using the FAVAR model to study the dynamic effects of three shocks—an unanticipated fall in the interest rates in the rest of the world, a demand shock in the rest of the world, and a supply shock in the rest of the world—on the UK economy, the authors infer that the domestic economy in the pre-1990 period shows an increase in UK real activity with a decrease in foreign money supply, and vice versa for the post-1990 period.

The FAVAR model captures the changing co-movements among macroeconomic time series. It incorporates time-varying coefficients and stochastic volatility in the shocks, thus allowing the relationships embodied in the model to change over time. The benchmark model is estimated using quarterly data from Q1 1974 to Q3 2010, spanning 17 countries and 558 series. The foreign block includes most of the main UK trading partners and the major industrialized economies around the world.

To model the interaction between the foreign and domestic blocks of the vector autoregression model, the authors use data covering prices, economic activity, and monetary indicators. The analysis is run in log differences (except interest rates), and the data are seasonally adjusted and standardized.

The authors indicate changes to the international transmission of shocks that coincide with significant changes to the UK policy framework. Their results suggest that international shocks have played an important part in driving such key UK macroeconomic variables as GDP and inflation.

The authors study the international transmission of structural shocks in an open-economy FAVAR model applied to the United Kingdom. They conclude that international shocks have affected such UK macroeconomic variables as GDP and inflation, especially during the 2008–10 crisis period. Their findings indicate changes in the effects of economic shocks on the UK economy between the periods before and after 1990. Further study on these changes could shed some light on the interactions between these changes and the international transmission mechanism.