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A time-varying estimation of an external reaction function for European Monetary Union countries: the role of risk-aversion and financial openness

Published online by Cambridge University Press:  17 July 2025

Mariam Camarero ,
Juan Sapena  and
Cecilio Tamarit Open the ORCID record for Cecilio Tamarit [Opens in a new window]
Mariam Camarero
Affiliation:
Universitat Jaume I and INTECO, Department of Economics, Castelløn de la Plana, Spain
Juan Sapena
Affiliation:
Catholic University of Valencia and INTECO, Economics Department, Valencia, Spain
Cecilio Tamarit*
Affiliation:
University of Valencia and INTECO, Department of Applied Economics II, Valencia, Spain
*
Corresponding author: Cecilio Tamarit; Email: cecilio.tamarit@uv.es
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Abstract

This paper aims at reexamining external sustainability in a dynamic framework for nine European Monetary Union (EMU) countries during the period 1970–2021. We extend the approach of Bohn (1998) to a time-varying external reaction function. The main advantage of our empirical strategy is that it captures the dynamics of the external reaction function, by accounting for the main sources of heterogeneity among EMU countries and by including common factors like financial globalization and global risk aversion. To estimate the model, we employ a fully fledged state-space framework, which extends the simple model generally used in this literature to a panel-data time-varying parameter framework, combining fixed (common and country-specific) and varying components. Our results show an evident interplay between real and financial variables, the latter progressively increasing their importance. Although heterogeneous, the adjustment to external imbalances in most EU countries is jointly driven by the level reached in the stock of net foreign assets together with the degree of risk aversion and financial openness.

Keywords

Current account imbalancespanel unit root testsmultiple structural breaksKalman Filtertime-varying parametersC23F32F36

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Type
Articles
Information
Macroeconomic Dynamics , Volume 29 , 2025 , e120
Copyright
© The Author(s), 2025. Published by Cambridge University Press

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