# **4.4 Country size or level of development?**

Our results for the variance decompositions and impulse response functions in the previous section comparing developed and developing countries have some similarities with our findings for small and large economies reported in Section 4.2. This is probably not surprising given that a few of the small economies also belong to the developed country group. To understand whether the results are being driven by the country size or the level of development we also summarize the variance decompositions from country-by-country VARs and estimate panel VARs while simultaneously conditioning on country size and developmental status.

Consider first, the variance decompositions obtained from the individual country SVARs. To assess the role played by country size versus developmental status we contrast the mean and median contributions of various shocks in small versus large economies, conditional on the level of development. Table 4 presents the results. Panel A reports the decompositions for developing countries, while panel B is for developed economies.

For developing countries, we find that the contribution of world interest rate shocks to GDP volatility is significantly lower in small countries, and so is the contribution of real exchange rate shocks. This is compensated by the greater role of domestic GDP shocks in small economies. All other shocks play comparable roles in small and large economies.

In developed countries, country size only influences the contribution of world demand shocks to GDP volatility, with larger countries affected more by these shocks. Domestic GDP shocks also make a bigger contribution to GDP volatility in small countries, but the difference in quantitatively small.

These results suggest that the majority of unconditional differences between large and small economies in the sources of business cycle volatility we uncovered in Section 4.2 are driven by the developing country group. Small developing countries are less susceptible to world interest rate shocks relative to large countries, which confirms our conjecture that size matters for access and degree of integration into international financial markets. Instead, small developing countries are more prone to domestic GDP shocks. The gap in the contribution of these shocks to GDP volatility is quite large, equal to 20% for the mean and 24% for the median. We conjecture that this gap is likely driven by omitted terms of trade shocks, shocks to weather conditions, and domestic technology and demand shocks. Several characteristics of small countries underlie this conjecture. First, small economies are more prone to weather shocks and natural disasters. Second, small economies are more concentrated in their production and exports, making them more susceptible to terms of trade and weather shocks. This amplifies the effects of shocks. Third, Hnatkovska and Koehler-Geib (2016) in their study of business cycle characteristics of small and large economies show that small countries exhibit stronger positive comovement between inflation and GDP suggesting that demand shocks play an important role in these countries. Below we check some of these conjectures by introducing terms of trade variable into country VARs. Unfortunately, due to lack of quarterly terms of trade data, we are only able to do so for a subsample of countries.

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