Modelling large open economies with international linkages: the USA and Euro area

Empirical modelling of the linkages between the euro area and the USA requires an open economy framework. The methodology proposed in this paper achieves identification of a structural vector error correction model by supplementing restrictions from economic theory with assumptions for the direction of causality in cross-country contemporaneous relationships. Our baseline model assumes contemporaneous causality runs from the USA to the euro area for both output and inflation, with monetary policy domestically focused. The role of the USA as leading the euro area business cycle is reinforced by our results, but strong bidirectional cross-country interactions are uncovered for inflation and interest rates.