Working Paper

Switching Volatility in a Nonlinear Open Economy

Abstract: Uncertainty about an economy’s regime can change drastically around a crisis. An imported crisis such as the global financial crisis in the euro area highlights the effect of foreign shocks. Estimating an open-economy nonlinear dynamic stochastic general equilibrium model for the euro area and the United States including Markov-switching volatility shocks, we show that these shocks were significant during the global financial crisis compared with periods of calm. We describe how U.S. shocks from both the real economy and financial markets affected the euro area economy and how bond reallocation occurred between short- and long-term maturities during the global financial crisis. Importantly, the estimated nonlinearities when domestic and foreign financial markets influence the economy should not be neglected. The nonlinear behavior of market-related variables highlights the importance of higher-order estimation for providing additional interpretations to policymakers.

Keywords: DSGE; Volatility Shocks; Markov Switching; Open Economy; Financial Crisis; Nonlinearities;

JEL Classification: C61; E32; F21; F41;

https://doi.org/10.24149/gwp386

Bibliographic Information

Provider: Federal Reserve Bank of Dallas

Part of Series: Globalization Institute Working Papers

Publication Date: 2020-05-28

Number: 386