Estimating a VECM for a Small Open Economy

In economic theory, the term small open economy refers to an economy that is too small to influence the surrounding world. The surrounding world can, for this reason, be seen as exogenous relative to the economy of this small open economy. The main contribution of this paper is the proposal of how to estimate a vector error correction model with exogeneity restrictions on the long-run and short-run adjustment parameters as well as on the short-run dynamic parameters between small open economies and the surrounding world. A Monte Carlo simulation study of impulse responses shows that the proposed method is considerably more efficient compared to models that fully or partially ignore the restrictions implied by the small open economy hypothesis. Using two Swedish macroeconomic datasets, we find that there are, for some variables, large differences in impulse responses between our proposed method incorporating the restrictions and models using no or partial restrictions. As the small open economy hypothesis is in many situations uncontroversial, our method enables the incorporation of indisputable economic theory into the econometric estimation of the model.