The transmission of foreign shocks to South Eastern European economies: A Bayesian VAR approach

Accepted Manuscript Title: The Transmission of Foreign Shocks to South Eastern European Economies: Bayesian VAR approach Author: Goran Petrevski Peter Exterkate Dragan Tevdovski Jane Bogoev PII: DOI: Reference:

S0939-3625(15)00048-5 http://dx.doi.org/doi:10.1016/j.ecosys.2015.04.003 ECOSYS 528

To appear in:

Economic Systems

Received date: Revised date: Accepted date:

16-9-2013 30-1-2015 3-4-2015

Please cite this article as: Petrevski, G., Exterkate, P., Tevdovski, D., Bogoev, J.,The Transmission of Foreign Shocks to South Eastern European Economies: Bayesian VAR approach, Economic Systems (2015), http://dx.doi.org/10.1016/j.ecosys.2015.04.003 This is a PDF file of an unedited manuscript that has been accepted for publication. As a service to our customers we are providing this early version of the manuscript. The manuscript will undergo copyediting, typesetting, and review of the resulting proof before it is published in its final form. Please note that during the production process errors may be discovered which could affect the content, and all legal disclaimers that apply to the journal pertain.

*Title page with author details

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Goran Petrevski, Ss. Cyril and Methodius University, Faculty of Economics, Goce Delcev 9B, 1000, Skopje, Macedonia

Peter Exterkate, University of Sydney, School of Economics, Room 343, Merewether Building H04, Sydney, NSW 2006, Australia



Dragan Tevdovski, Ss. Cyril and Methodius University, Faculty of Economics, Goce Delcev 9B, 1000, Skopje, Macedonia



Jane Bogoev, 1818 H Street, Washington, DC 20433, USA1

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Corresponding author:

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Goran Petrevski, Ss. Cyril and Methodius University

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Faculty of Economics

1000 Skopje Macedonia

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Tel.:+ 389 2 3286 878

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Goce Delcev 9B

Fax:+ 389 2 3118 701

E-mail: [email protected]

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While working on the paper, Jane Bogoev was with the Research Department, National Bank of the Republic of Macedonia.

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*Manuscript (without author details) Click here to view linked References

The Transmission of Foreign Shocks to South Eastern European Economies: Bayesian VAR approach Abstract The paper analyses the macroeconomic effects of foreign shocks in three South-East European (SEE)

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economies: Croatia, Macedonia and Bulgaria. In these regards, we investigate the transmission of several eurozone shocks (output gap, money market rates and inflation) on various macroeconomic variables in afore

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mentioned countries (output, inflation, money market rates, and budget deficits). We trace the effects of foreign shocks on the basis of impulse response functions obtained from the Bayesian Vector Auto Regressions (VARs) for each country, separately. The main findings from our study are: first, economic expansion in the euro-zone

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has strong output and inflation effects on SEE economies, implying some degree of synchronization of business cycles; second, euro-zone inflation is instantly and to great extent transmitted to domestic inflation, suggesting

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that inflation in SEE economies is mostly driven by foreign inflation; third, domestic money market rates are not closely linked with euro-zone money markets; fourth, monetary policy in SEE countries does not seem to be responsive to euro-zone inflation shocks; finally, fiscal authorities attempt to offset the spillover effects from

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both economic expansion and monetary tightening in the euro-zone.

Key words: Monetary Policy, Bayesian Vector Autoregression, Exogenous shocks.

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1. Introduction

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JEL codes: C3, E52, E58, E61

In 2007, Bulgaria and Romania joined the European Union (EU), followed by Croatia in 2013, while Macedonia is still on the accession road with a candidate status. At present, all the three countries have some form of rigid exchange rate regimes - a currency board in

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Bulgaria, and currency pegs in Croatia and Macedonia. Finally, these countries share another common feature: they are small open economies with close trade and financial links with the EU. As they advance in their integration within the EU, sooner or later they will face another important challenge, namely, the adoption of the single currency. These stylized facts provide the main motivation for our interest in the transmission of foreign shocks originating from the euro-zone. 1

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Recently, reflecting the EU accession process, an array of empirical literature has emerged focusing on the transmission of foreign shocks in former transition economies dealing with different issues related with the links between these economies and the EU: some papers track the degree of business cycle synchronization (Aslanidis 2010, Benčík 2011, Eickmeier and Breitung 2006, Fidrmuc and Korhonen 2003 and 2006, Frenkel and Nickel 2005, Korhonen 2003, Petrovska 2012, Velickovski 2010 and 2013), while others

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investigate the channels in the transmission of foreign shocks and/or the reaction of domestic policies to foreign shocks (Balabanova and Brüggemann 2012, Benczur et al. 2004,

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Benkovskis et al. 2011, Crespo-Cuaresma et al. 2011, Horváth and Rusnák 2009, Jiménez-

Bogoev 2012, Unevska-Andonova and Petkovska 2011).

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Rodriguez et al. 2010, Krznar and Kunovac 2010, Minea and Rault 2011, Petrevski and

Our paper adds to the latter strand of the empirical literature with two contributions:

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first, we explore the effects of foreign shocks on domestic policies, including the response of fiscal policy, which is often omitted in most of the papers; second, we estimate the impulse response functions relying on the Bayesian VAR methodology, which appears to be

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preferable over the standard estimation procedure of VARs.

Specifically, we provide empirical evidence on the effects of various euro-zone

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shocks (output gap, inflation, and money market rates) on several macroeconomic variables in the SEE countries (output gap, inflation, money market rates and budget surpluses) based on the impulse response functions estimated within the Bayesian VAR methodology. The

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Bayesian approach successfully overcomes the risk of overfitting the data and imprecise inference due to the rich parameterization of VAR models, which is extremely important in the case of SEE economies where available data series are short. To the authors’ best knowledge, the present paper is the first to apply Bayesian VARs in modeling the

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transmission of foreign shocks to SEE economies. We follow the methodology presented in Koop and Korobilis (2009) using the independent normal-inverse-Wishart prior. The prior captures widely held beliefs about the long-run properties of the data, properties that are not readily apparent in the short samples typically used for estimation. Bayes’ theorem then provides the optimal way of combining these two sources of information leading to sharper inference and more precise forecasts (Karlsson, 2012). 2

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Generally, the estimated results imply economic expansion in the euro-zone has strong output and inflation effects on SEE economies, implying some degree of synchronization of business cycles. Moreover, the results also suggest that the more domestic economy is integrated with the EU, the more persistent are the effects of exogenous shocks. An additional finding is that euro-zone inflation is instantly and to great extent transmitted to domestic inflation, suggesting that inflation in SEE economies is mostly driven by foreign

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inflation. We can explain these effects by several factors, such as: the high trade openness of SEE economies, the integration of SEE financial markets to EU financial markets as well as

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the dependence of banks on foreign financing. Yet, despite the presence of rigid exchange rate regimes, we find that neither domestic money market rates are closely linked with euro-

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zone money markets nor monetary policy makers in SEE countries seem to be responsive to euro-zone inflation shocks. On the other hand, it is the fiscal authorities that attempt to offset

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the spillover effects from both economic expansion and monetary tightening in the euro-zone. The rest of the paper is organized as follows: Data description and the estimation

Section 3, while Section 4 concludes.

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2. Data and methodology

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method are presented in Section 2. The findings of the empirical study are presented in the

Our empirical model comprises two sets of variables - domestic variables and foreign

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variables with quarterly data. The former include: the primary cyclically-adjusted government balance (as a ratio of GDP), money market interest rates (for Croatia and Macedonia) and the M0-to-GDP ratio (for Bulgaria), inflation rate (CPI-based), and output gap. As for the foreign variables, we take the euro-zone output gap, 3-month Euribor, and

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euro-zone inflation. The output gap is calculated as a percentage difference between the actual and potential GDP. In estimating potential GDP and output gap we rely on the onesided Hodrick-Prescott (HP) filter with the default lambda of 1600 (λ=1600), instead of the most commonly used two-sided HP filter method estimated from the whole sample. The reason is that the two-sided approach introduces trends that were not known at the time of shocks, which can substantially confound the estimated effects of shocks. Some of the series, 3

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such as real GDP, inflation and fiscal data (government revenues and expenditures), have been seasonally adjusted by the "CENSUS X-12" method. In what follows we provide a brief explanation of domestic fiscal and monetary policy variables. Primary cyclically-government balance is used as an indicator of fiscal policy (general government in Bulgaria, while central government in Croatia and Macedonia due to data availability issues). We have chosen to work with primary government balance, i.e. to

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exclude interest payments from total government expenditures because interest payments represent an exogenous category. Specifically, in designing current fiscal policy, interest

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payments are taken as an exogenous factor, which is determined by the past fiscal policy decisions related to public borrowing. For the three countries, fiscal revenues and

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expenditures have been adjusted according the Governmental Financial Statistics (GFS) 2001 methodology.

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For Croatia and Macedonia, we use money market interest rates as indicators of monetary policy. Certainly, due to the features of the currency board and the full capital account liberalization, the central bank of Bulgaria is not able to exert control on domestic

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money market rates (Minea and Rault 2011). Therefore, we use the M0-to-GDP ratio as some rough proxy of monetary policy in Bulgaria (though an imperfect one, admittedly). We

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decided to use this indicator because the Bulgarian National Bank may have retained some influence on banks' reserves through the reserve requirement, especially having in mind the unorthodox nature of the currency board, i.e. the excess coverage with foreign reserves.

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Nevertheless, we are aware of the weakness of this monetary policy indicator, and, consequently, one need to be very cautious in interpreting the results of the analysis based on this indicator.

We have checked the stationarity of the time series by means of several unit root tests,

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such as: the Augmented Dickey-Fuller (ADF) with various lag-length selection criteria (Akaike, Schwarz and Hannan-Quinn), Phillips-Perron (PP), and Kwiatkowski-PhillipsSchmidt-Shin (KPSS) tests. The unit root tests reveal that all the series are stationary, except for the money market rates in the euro-zone, Croatia and Macedonia a well as the M0-toGDP ratio. These series have been first differenced in order to obtain stationarity.1 1

The results are not shown due to space considerations. However, they are available by the authors upon request.

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For Bulgaria, the sample begins at the first quarter of 1999, i.e. the sample excludes the highly unstable macroeconomic environment in late 1990s. For Macedonia, the sample starts in the first quarter of 2000, when the new monetary policy instrument had been introduced. Similarly, in order to avoid the effects of the 1998-1999 banking crisis in Croatia, the sample starts from the second quarter of 2000. For all the countries the sample ends at the last quarter of 2011.

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The estimation method applied in this research is based on the Bayesian VAR methodology, which recently has gained popularity in the evaluation of the effects of

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macroeconomic shocks (For instance, see Doan et al. 1984, Litterman 1986, Sims and Zha 1998, Ritschl and Woitek 2000, Uhlig 2005, Caldara and Kamps 2008, Afonso and Sousa

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2009, and Mountford and Uhlig 2009). The Bayesian approach offers a solution to the dimensionality problem by shrinking the parameters via the imposition of priors. Koop and

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Potter (2003), Wright (2003), and Stock and Watson (2005a, 2006) explore the performance of the Bayesian approach in relatively small systems, while De Mol et al. (2008) and Banbura et al. (2010) confirm its validity even in systems with a large number of predictors compared

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to the small sample sizes that are typical in macroeconomic analysis. We employ Bayesian VARs with an independent normal-inverse-Wishart prior, which

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has become standard in the literature; see e.g. Kadiyala and Karlsson (1997) and Banbura et al. (2010). We take the set of prior hyper parameters from this last paper, where it is shown to work well in overcoming the problem of working with high-dimensional models for short

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data samples. For each country separately, we estimate a Bayesian VAR including the following variables: yf; if, and πf, which denote the output gap, the money market rate, and inflation rate in the euro-zone, respectively; and the domestic variables -yd, Fd,id, and πd, which refer to the output gap, the fiscal policy indicator, the monetary policy indicator, and

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inflation, respectively.

We employ the recursive approach for identification of shocks, which has been

employed by Christiano et al. (1999), Bernanke et al. (2005b), Stock and Watson (2005), Banbura et al. (2010), and several other studies that are addressing similar questions to ours. We are aware that the choice between the alternative approaches in the identification of shocks (recursive, structural or sign restrictions) is always a controversial one. In the context 5

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of the present paper, we believe that the differences that would arise from switching to a structural identification scheme would be extremely minor. On the one hand, the recursive scheme is just a special case of the structural scheme that arises from the identifying assumptions implied by the ordering of the variables. In our study, these assumptions seem very reasonable. In particular, the key assumption that domestic shocks in small open economies do not have a contemporaneous impact on foreign macroeconomic aggregates

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would likely also be made in any structural VAR. Since the main objective of this paper is to understand the transmission of euro-zone shocks to small open SEE economies, we believe

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that our decision to estimate a recursive rather than a structural VAR cannot have an appreciable impact on the results.

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Specifically, we impose the following restrictions in the VARs: a) foreign variables are allowed to have contemporaneous impact on domestic variables in the three countries

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while the opposite relationship is precluded; b) both in the euro-zone and in the three countries, economic activity contemporaneously influencesfiscal and monetary policies, but not vice versa, because they affect the real sector with a certain time lag (see Blanchard and

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Quah 1989); c) similarly, both in the euro-zone and the three countries, economic activity and economic policies have contemporaneous impact on inflation.

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Moreover, one should note that the above restrictions refer to the contemporaneous impact between the variables included in the VARs, but they do not restrict the effects of lagged values of one variable to the rest of the system. However, we build our model on the

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assumption that the euro-area affects exogenously the SEE countries due to their small open economy features. In contrast, these economies cannot influence economic developments and economic policies in the euro-zone. Therefore, we follow Cushman and Zha (1997) and impose the block-exogeneity restriction in the VARs such that the lags of foreign variables

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are included in the equations of domestic variables, while the lags of domestic variables are excluded from the equations offoreign variables. The lag-length of one quarter is used in all three VARs, based on the Bayesian information criteria.

3. Discussion of the results

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In this section we interpret the impulse responses from the Bayesian VARs (See Appendix). In assessing the IRFs we calculate the 95% Bayesian highest posterior density sets, which are analogous to confidence bands in classical statistics. In what follows, we discuss the impulse responses generated by the shocks in foreign variables (the output gap, Euribor and inflation in the euro-zone, respectively).

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3.1 Foreign output shock

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Panel A of the Appendix shows the effects of euro-zone output shocks on SEE countries. As can be seen, a positive shock to the euro-area output gap with a magnitude of one standard

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deviation has strong effects on domestic economic activity in the three economies. The impulse responses are highly significant. The responses to the foreign shock peak after four

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quarters in Bulgaria and Croatia where the reaction of domestic economic activity is stronger and more persistent as compared to Macedonia, which has not yet started the negotiation process for joining the EU. These findings can be interpreted as evidence for some degree of

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synchronization of business cycles between the euro-area and the three SEE economies, which reflects the high trade openness of these economies whose exports are sold mainly in

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the EU. In addition, our results suggest that the capital channel, too, may be important in the transmission of foreign shocks as most of the capital inflows in these countries originate from the EU. As foreign capital is mostly attracted by the countries with closer political and

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economic links with the EU (Bulgaria and Croatia) it may explain the differences in the magnitude of IFRs between these two countries and Macedonia. In this respect, it seems that the synchronization of business cycles depends on the level of integration of SEE economies with the EU (Jiménez-Rodriguez et al. 2010; Petrovska 2012; Velickovski 2010 and 2013).

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At the same time, changes in the euro-zone economic activity exert positive effects on

domestic inflation in the three economies. As the euro-area economic expansion spurs domestic economic activity, this creates an upward pressure on domestic inflation through the higher domestic demand (demand side pressure). The magnitude of the reaction of inflation is larger in Croatia, where the IFRs die out relatively quickly (after the third quarter), in comparison with Bulgaria and Macedonia, where the inflationary effects are more persistent. 7

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As for the fiscal policy behaviour, there is a significant reaction of the cyclicallyadjusted budget balance in all the three economies where fiscal policy tightens responding to a positive shock in the euro-area output gap. This might reflect the attempts of policymakers to offset the spillover effects from the EU-wide expansion (positive aggregate demand shocks) by tight fiscal policy, i.e. to exploit the favourable external environment to improve the fiscal balance. This result is in line with the models that suggest the use of countercyclical

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discretionary fiscal policy behaviour at individual country level within the EU (Beetsma and Jensen 2002; Bryson 1993; Galí and Monacelli 2008).

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Surprisingly, despite the similar exchange rate regimes, the response of monetary policy to foreign economic expansion differs across the three countries: in Bulgaria, there is

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short-lived increase in the M0-GDP ratio reflecting the economic expansion through the standard money demand function; in Croatia, interest rates moves erratically, i.e. first, they

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decline, perhaps reflecting the tightened fiscal policy, followed by a quick reversal as a response to rising inflation; in Macedonia, they remain insignificant implying a neutral

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response of monetary policy makers.

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3.2 Foreign interest rate shock

Panel B of the Appendix show the response of domestic variables in SEE to an interest rate shock originating in the euro-zone. A positive foreign interest rate shock (a rise in the 3-

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month Euribor) produce similar effects in the three SEE economies: initially, domestic economic activity declines, but in a period of around one year the economy rebounds. In Macedonia, the IRFs are statistically insignificant, in part reflecting the lower level of EU integration compared to Bulgaria and Croatia. The decline in domestic output lasts for three

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quarters in Bulgaria, while in Croatia the negative impact is much shorter (up to one quarter) and then it reverses to a positive reaction with a lag of six quarters. The negative output effects of foreign interest rate shocks could be explained by the costs of external financing of the private sector (both banks and companies) in SEE countries. For instance, following a rise in the Euribor, the companies' borrowing costs increase as well. This, in turn, reduces their rate of return of new investments, which might lead to lower investment with a negative 8

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impact on domestic economic activity. Moreover, another channel may be the banking sector, which is predominantly foreign-owned in these countries. Here, the higher Euribor increases the borrowing costs of domestic banks, which might also hurt their profitability. As a result, the banks may reduce lending, which may negatively affect domestic economic activity (Bogoev 2011). Surprisingly, a rise in the Euribor leads to an increase in domestic inflation in Croatia

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and Macedonia, which is counterintuitive bearing in mind their openness as well as the rigid exchange rates. Although this is a puzzling result, it may be explained with the uncertainty of

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economic agents as to how domestic monetary and fiscal policy makers would to the monetary tightening in the euro-area. Consequently, this uncertainty might be built in the

though the impulses are not statistically significant.

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companies’ price-setting decisions. In Bulgaria, the effects are expected (lower inflation),

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The response of fiscal policy to a rise in the foreign interest rates is very similar across the SEE economies (both in the shape and the magnitude): initially, fiscal authorities pursue loose fiscal policy attempting to offset the negative output effects, but this behaviour

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is short-lived as output recovers quickly. Perhaps, fiscal expansion, in part, accounts for the inflationary pressures observed in Croatia and Macedonia following the monetary tightening

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in the euro-zone.

Further on, a positive shock to the foreign reference rate triggers a significant increase in domestic money market rates only in Macedonia, lasting for more than a year. In Croatia,

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the response of domestic market rate is quite oscillating. Initially, the rise in the Euribor has a negative impact on the domestic money market rate, but soon this counterintuitive response disappears and, after three quarters, domestic interest rates increase. The results for Croatia suggest that the central bank, which throughout the sample period has implemented a series

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of non-interest rate measures (see Kraft 2003; and Lang and Krznar 2004), may have preserved some autonomy in the conduct of monetary policy. In the case of Bulgaria, the shock in the Euribor has a negative effect on the M0-to-GDP ratio, which is in line with the prior expectations that, under a currency board, foreign monetary contraction is transmitted into domestic economy. However, the impulses in Bulgaria are not statistically significant,

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which supports the results by Minea and Rault (2011), who find that Bulgarian interest rates and money supply are not linked with ECB’s interest rates in the short-run.

3.3 Foreign inflation shock

The response of domestic variables in SEE countries to a shock in foreign inflation are shown

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in Panel C of the Appendix. The IRFs of domestic inflation for all the three countries are as expected. There is immediate positive and statistically significant reaction, though it is short-

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lived: the impulses decay relatively quickly and become insignificant after the first quarter in Bulgaria, after the third quarter in Croatia and after the fourth quarter in Macedonia. The size

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of the reaction of domestic inflation is much larger in Bulgaria and Croatia as compared to Macedonia. These findings imply that domestic inflation in the SEE economies is closely

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linked with the euro-zone inflation, which accords well with a priori expectations for small economies with fixed exchange rates and high level of trade openness. Domestic output in the three economies increases in response to a positive inflation

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shock in the euro-zone via the trade channel: higher aggregate demand in the euro-zone leads to an increase in exports in the SEE countries, thus, spurring economic activity. The response

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of domestic output is most persistent in Bulgaria, while the IRF is not statistically significant in Croatia.

As for the reaction of policy makers to a shock in the euro-zone inflation, the IRFs

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suggest that fiscal authorities react countercyclically in the attempt to offset the spillover effects. Yet, the impulse responses are not statistically significant in Croatia and Macedonia, while fiscal policy in Bulgaria respond with a certain lag. In sum, it seems that fiscal authorities in SEE countries are not concerned with effects of foreign inflation on domestic

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economy, probably leaving this task to their central banks. Finally, a positive shock in foreign inflation leads to an increase in domestic money

market rates only in Macedonia, where the response is immediate though short-lived. The behaviour of money market rates in Croatia is counterintuitive and the impulse responses are statistically insignificant. In Bulgaria, the M0-to-GDP ratio falls, though it is not statistically significant, too. The positive reaction of domestic money market rates in Macedonia to a 10

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shock of foreign inflation is consistent with the reaction of money market rates to the Euribor (as explained above). Specifically, when the euro-zone inflation intensifies, the ECB raises its key policy rate, which affects is transmitted on the Macedonian money market rate. In Bulgaria, the decline in the M0-to-GDP ratio is in line with the standard money demand theory, i.e. as higher foreign inflation increases the risk of rising domestic inflation economic agents reduce their cash balances. Finally, the absence of response in the money market rates

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consequence of the massive use of various non-interest rate measures.

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in Croatia supports the notion that the central bank might retain some maneuver room, a

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4. Conclusions

This study examines the transmission of foreign shocks to three SEE economies with fixed

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exchange rate regimes: Bulgaria, Croatia and Macedonia. Specifically, we trace the response of several domestic macroeconomic variables (output, inflation, interest rates and budget balance) to euro-zone shocks (output, interest rates and inflation), based on the impulse

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response functions estimated with Bayesian VARs.

Generally, the estimated resultsimply that economic expansion in the euro-zone has

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significant and relatively strong output and inflation effects on SEE economies. These findings imply some degree of synchronization of business cycles between the euro-zone and SEE economies. Moreover, the results also suggest that if domestic economy is more

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integrated with the EU, then the effects of exogenous shocks are stronger and more persistent. An additional finding is that euro-zone inflation is instantly and to great extent transmitted to domestic inflation, suggesting that inflation in SEE economies is mostly driven by foreign (euro-zone) inflation.

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As for the reaction of economic policy in SEE countries to euro-zone shocks, we find

that domestic money market rates are not linked with the Euribor, which could be interpreted that central banks in SEE do not follow closely the ECB’s monetary policy. Similarly, domestic monetary policy does not seem to respond to euro-zone inflation shocks, despite their quick transmission to these economies, while the reaction to foreign output shocks is quite heterogeneous across the three countries. In sum, it appears that monetary policy is not 11

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responsive to euro-zone shocks notwithstanding the prevailing rigid exchange rate regimes. On the other hand, we find evidence that fiscal authorities attempt to offset the spillover effects from both economic expansion in the euro-zone and ECB’s monetary tightening.

ACKNOWLEDGMENTS This research was supported by a grant from the CERGE-EI Foundation under a programme

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of the Global Development Network. The authors are grateful to the Journal’s Editor, the two anonymous referees, Sergey Slobodyan, Karsten Staehr, Magdalena Petrovska, Marjan

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Petreski as well as conference participants in Prague, Skopje and Banja Luka for their helpful comments and suggestions. All opinions expressed are those of the authors and have not been

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endorsed by CERGE-EI, GDN or the National Bank of the Republic of Macedonia.

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Wright, J (2003) “Forecasting U.S. Inflation by Bayesian Model Averaging”. International

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Finance Discussion Papers 780, Board of Governors of the Federal Reserve System

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Figure

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Appendix: IRFs of Bayesian VAR with 95% confidence intervals

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A: Impulses generated from the output gap shock in the euro-zone

Impulse responses of domestic output gap: Croatia

Macedonia

ed

M an

Bulgaria

Croatia

Macedonia

Ac

Bulgaria

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Impulse responses of fiscal policy:

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Croatia

ip t Macedonia

ed

M an

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Bulgaria

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Impulse responses of monetary policy:

Impulse response of domestic inflation: Croatia

Macedonia

Ac

ce pt

Bulgaria

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B: Impulses generated from the 3-month Euribor shock Impulse responses of domestic output gap: Croatia

Macedonia

ed

M an

us

Bulgaria

Impulse responses of fiscal policy: Croatia

Macedonia

Ac

ce pt

Bulgaria

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Croatia

ip t Macedonia

M an

us

Bulgaria

cr

Impulse responses of monetary policy:

ed

Impulse response of domestic inflation: Croatia

Macedonia

Ac

ce pt

Bulgaria

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C: Impulses generated from the euro-zone inflation shock Impulse responses of domestic output gap: Croatia

Macedonia

ed

M an

us

Bulgaria

Impulse responses of fiscal policy: Croatia

Macedonia

Ac

ce pt

Bulgaria

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Croatia

ip t Macedonia

M an

us

Bulgaria

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Impulse responses of monetary policy:

Impulse response of domestic inflation: Croatia

Macedonia

Ac

ce pt

ed

Bulgaria

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*Highlights (for review)

The Transmission of Foreign Shocks to South Eastern European Economies: Bayesian VAR approach



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(Highlights for review)

This is a completely revised version of our previous paper titled as “The Transmission of

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Foreign Shocks to South Eastern European Economies”. In the revised paper we estimate 

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the VAR by employing the Bayesian approach.

This paper investigates the transmission of foreign shocks to economic activity and macroeconomic policies in three South Eastern European (SEE) economies: Croatia,



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Macedonia and Bulgaria.

We provide empirical evidence on the influence of several policy and non-policy shocks

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(the output gap, the money market rate and the inflation rate in the euro-zone) on monetary and fiscal policies and economic activity in the analysed countries. We trace the effects of foreign shocks on the basis of impulse response functions

d



obtained from the Bayesian Vector Auto Regressions by explicitly taking account of the

The estimated results imply that economic expansion in the euro-zone has strong output

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

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exogeneity of foreign shocks.

and inflation effects on SEE economies, implying some degree of synchronization of business cycles. 

The results also suggest that euro-zone inflation is instantly and to great extent transmitted to domestic inflation, suggesting that inflation in SEE economies is mostly driven by foreign inflation.



An additional finding is that domestic money market rates are not closely linked with euro-zone money markets.



Finally, fiscal authorities attempt to offset the spillover effects from both economic expansion and monetary tightening in the euro-zone.

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