Factor models and MCMC methods for the analysis of the sources and transmission of international shocks

This dissertation applies dynamic factor analysis to investigate the sources and channels of transmission of shocks from large to small open economies. There are two main objectives to this study. The first goal is to present methods for conducting inference in dynamic factor models using Markov Chain Monte Carlo techniques. The second objective is to use these methods to uncover the origins and propagation mechanisms of disturbances that can account for the observed synchronization of economic fluctuations across countries.; The first chapter is methodological in nature and begins by introducing the dynamic multi-factor framework. The presentation focuses on how to conduct inference under exclusion restrictions and heterogeneous dynamics using simulation techniques. One crucial issue dealt with at length is how to infer the number of factors, which is cast as a model selection problem. The performance of various proposals for selecting competing models is surveyed through extensive simulations.; The second chapter applies these methods to the case of Australia and Canada in order to investigate the sources and propagation mechanisms of foreign shocks affecting these two economies. The discussion highlights the advantages of the dynamic multi-factor methodology over previous empirical work in this area. One particularly attractive feature of this framework is the possibility of computing impulse responses that are then used to suggest a structural interpretation to the factors. In order to bridge theory and empirics, a small open economy model is calibrated for the Australian economy. The theoretical impulse responses are contrasted with those obtained from the inferred factors. This analysis reveals that innovations in highly integrated equity markets are associated with comovements in investment that are critical in explaining cofluctuations in economic activity across countries. Therefore, the omission of traded capital goods in small open economy models represents an important shortcoming of theoretical frameworks in the literature.