Empirical Studies of Equilibrium-Correction Dynamics and Financial market Linkages in the Macroeconomy.

We apply a general-to-specific modelling approach to estimate a six-dimensional parsimonious structural vector error-correction model of the US economy. We use graph theory methods to determine the instantaneous causal structure of the system from the data thus, overcoming the common problem of making ad-hoc assumptions about the order of causality. Model reduction procedures allow us to control for the curse-of-dimensionality inhibiting such high-dimensional vector autoregressive systems. The corporate-government bond yield risk premium is identified as one of five cointegration relations characterising the economy. Monetary policy reacts to the risk premium and

the term structure of interest rates long-run relationships. Monetary policy is also neutral in the long-run, with a contractionary shock to the federal funds rate leading to only a temporary increase in bond yields and fall in inflation and capacity utilisation. In addition, corporate bonds react faster and by more than do Treasuries, making the corporate-government bond yield spread a potential target in implementing monetary policy.

Joint modelling of fiscal and monetary policies should elucidate on their interaction. We construct an eight-dimensional parsimonious structural vector equilibrium correction model of the US macroeconomy over the last five decades. The fiscal deficit is found to be one of five cointegration vectors, constraining fiscal policy in the long-run. In contrast, the share of the government sector is found not to be mean reverting. Impulse-response analysis of the parsimonious system facilitates precise measurement of the dynamic Keynesian fiscal multiplier, where we distinguish between deficit-spending and balanced-budget spending shocks (as in the so-called Haavelmo, 1945, theorem). Our estimates of the long-run multiplier are 1.62 for a bond-financed spending shock and 1.77 for a tax-financed spending shock, with both being greater than 1 and significant at a 95% confidence level. Monetary policy is neutral in the long-run except for the level of output on which a permanent effect is observed. Increasing the federal funds rate by a percentage point is followed by falling tax revenues while government spending is largely unchanged, thus inflating the fiscal deficit in the short-run and medium-run.

One aspect of increasing inter-dependence between economies can be seen in the internationalisation of financial markets. We investigate the propagation of domestic and foreign shocks through US and UK financial markets for money, bonds, equities, and the exchange rate. We focus on within-market, cross-market, and cross-border linkages. This study is especially relevant for small, open economies which are most exposed to foreign-originated shocks. US markets dominate cross-border spillover effects and explain about 7.5% of the variation in UK asset markets. This is in contrast to the 0.15% of the variation in US financial markets that is explained by shocks from UK markets. The strongest effects are in equity and money markets. Own idiosyncratic shocks have the

highest explanatory power and account for 54%-94% of the variation in returns.