Sources of macroeconomic fluctuations in small open economies

This paper examines the sources of economic fluctuations in seven OECD small open economies. We measure the relative contribution of external shocks and country-specific aggregate demand and supply disturbances (internal shocks) in explaining short-term movements of output, inflation and the trade balance. We find: (i) output fluctuations are primarily explained by domestic supply shocks, (ii) trade balance movements are explained mostly by domestic absorption shocks, and (iii) spillover effects of external shocks on the domestic economy are primarily on nominal, rather than real, variables. We conclude that, while domestic absorption policies like fiscal restraint may improve the trade balance, they cannot stabilize output.