MODELLING EXTERNAL SHOCKS IN A SMALL OPEN ECONOMY: THE CASE OF IRELAND

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Date: May 2018
Publisher: Sage Publications Ltd. (UK)
Document Type: Report
Length: 5,110 words
Lexile Measure: 1520L

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The Irish economy has recovered at an impressive pace from the economic and financial crisis that lasted from 2008-12. Nonetheless, as a small open economy with some lingering vulnerabilities from the recent crisis, the economy remains heavily exposed to potential adverse shocks. In this paper, we explore the possible impact of external shocks on the Irish economy. We model the shocks in a two-stage process: first using NiGEM to estimate the impact on Ireland's key trading partners and the broader international environment and then examining the effect of these changes in the COSMO model of the Irish economy. The paper focusses on three relevant risks facing the economy: the potential for a hard Brexit, an increase in interest rates and a depreciation of the sterling euro exchange rate. Using this two-step approach allows us to demonstrate the transmission of external shocks to the Irish economy. The results help to quantify the potential impact on future growth, the labour market, public finances and the financial system of some key risks materialising.

Keywords: macroeconometric model, model simulations.

JEL codes: C32, C50, C53.

1. Introduction

Following the deep recession caused by the onset of the international financial crisis and the collapse of a domestic property bubble, the Irish economy has experienced a robust recovery. Since 2013, when the country exited the EU-IMF financial support programme, domestic demand has grown at an average annual rate of 5.2 per cent, the unemployment rate has fallen from just over 16 per cent to 6 per cent and the budget deficit has declined from a record 32 per cent of GDP in 2010 to close to a balanced budget position in 2017. Given the depth and severity of the 2008-12 crisis, the pace of this recovery has surprised many forecasters, and current projections for the Irish economy envisage a continuation of strong growth over the short and medium term. However, while uncertainty is an ever-present dimension of all forecasting exercises, the outlook for the Irish economy is currently clouded by the presence of a large number of risks related to the external environment.

Because of the uncertainty about the future path of the economy, it is useful to explore the possible effects on future growth of changes in a selection of key external variables. As an exceptionally globalised economy, with exports amounting to more than 120 per cent of GDP, the Irish economy is particularly exposed to external shocks. This exploration can help us gain a better understanding of what drives the economy in the medium term and what are the important factors that will affect the actual outturn.

In considering the impact of external shocks on the Irish economy, it is important to ensure that the modelling approach chosen takes into account in a consistent manner all of the key channels through which such shocks could impact Ireland. Taking the example of an increase in interest rates, such a shock would directly increase the cost of borrowing for Irish firms and households and could reduce investment, and...

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Gale Document Number: GALE|A542404552