Measuring the effects of dollar appreciation on Asia: A FAVAR approach

Abstract

Exchange rate shocks have mixed effects on economic activity in both theory and empirical VAR models. In this paper, we extend the empirical literature by considering the implications of a positive shock to the U.S. dollar in a factor-augmented vector autoregression (FAVAR) model for the U.S. and three large Asian economies: Korea, Japan and China. The FAVAR framework allows us to represent a country's aggregate economic activity by a latent factor, generated from a broad set of underlying observable economic indicators. To control for global conditions, we also include in the FAVAR a "global conditions index," which is another latent factor generated from the economic indicators of major trading partners. We find that a dollar appreciation shock reduces economic activity and inflation not only for the U.S. economy, but also for all three Asian economies. This result, which is robust to a number of alternative specifications, suggests that in spite of their disparate economic structures and policy regimes, the dollar appreciation shock affects the Asian economies primarily through its impact on U.S. aggregate demand; and this demand channel dominates the expenditure-switching channel that affects a country's export competitiveness.

International Transmission of Japanese Monetary Shocks Under Low and Negative Interest Rates: A Global Favar Approach

“…These results are similar to those found for U.S. exchange rate shocks in Liu et al (2017), which find a positive impact of U.S. exchange rate depreciation on major Asian trading partners, again suggesting that expenditure-switching considerations dominate terms-of-trade implications of exchange rate shocks for major Asian nations.…”

“…We examine the implications of these shocks using the global factor-augmented vector autoregression, or FAVAR, specification of Liu et al (2017). That paper extends the FAVAR framework of Bernanke and Boivin (2003) and Bernanke et al (2005) to evaluate sensitivities to external exchange rate shocks.…”

“…In addition to the conventional FAVAR approach for the representation of a local conditions index (LCI), Liu et al (2017) also estimates a latent index of foreign activity, weighted by trade volumes for a country's prominent trading partners. This country-specific "global conditions index" (GCI) provides a novel way of conditioning for changes in foreign activity and assists in isolating specific external shocks.…”

“…The GCI should also prove useful for our efforts here to gauge the global impacts of Japanese monetary policy shocks. By including the GCI, the Liu et al (2017) FAVAR can isolate the impacts of the Japanese shocks from other global developments.…”

“…We follow Liu et al (2017) in measuring domestic activity as a latent variable, which is extracted from a wide range of published time-series data. We term this latent variable our "local conditions index" (LCI).…”