about 6 quarters in smaller countries. The expansion is statistically significant in both groups of economies. The improvement in GDP following real appreciation may seem puzzling if one expects real appreciation to be accompanied by trade and current account deterioration. Note, however, that we are already controlling for trade balance response in our estimation. Thus, the influence of real exchange rate on GDP is already purged of the trade balance channel. Instead, we interpret the improvement in GDP following real exchange rate appreciation as indicative of the importance of demand-side shocks.<sup>4</sup> Such shocks lead the real exchange rate and GDP to move in the same direction, as greater demand is accompanied by higher prices of tradable and non-tradable goods, and higher output. Our results indicate that these shocks are more persistent in larger economies.

Lastly, turning to trade balance, we find that an unanticipated improvement in trade balance leads to contrasting responses of GDP in small and large economies. Specifically, following these shocks GDP rises in small countries, but falls in large economies. Notice, however, that the fall in GDP experienced by larger economies is small and very short-lived.

# **4.3 Individual and Panel VAR Results by Level of Development**

Next, we subdivide countries by their income level and contrast their sources of volatility. We combine countries classified by the World Bank as low income and middle income countries into a “developing” countries group, while high income OECD and non-OECD countries are combined into a “developed” countries group. As before we report the number of countries, and crosscountry mean, median, 25<sup>th</sup> , and 75<sup>th</sup> percentiles of the contribution that each variable included in the SVAR makes to GDP volatility for each income group. We also compute the difference in mean and median contributions between developed and developing countries, together with their statistical significance level. These results are summarized in Table **3** .

**Table 3. Variance decomposition of GDP volatility: By level of development**

|||**Dev**|**eloping cou**|**ntries**|||**De**|**veloped cou**|**ntries**||**mean diff**|**median diff**|
|---|---|---|---|---|---|---|---|---|---|---|---|---|
||N|mean|median|p25|p75|N|mean|median|p25|p75|||
|**rrate_us**|20|0.119|0.086|0.043|0.134|28|0.110|0.078|0.038|0.153|-0.009|-0.008|
|**(log) gdp_us**|20|0.078|0.043|0.023|0.096|28|0.135|0.077|0.014|0.219|0.057|0.034|
|**(log) govexp**|20|0.128|0.093|0.027|0.170|28|0.082|0.059|0.014|0.124|-0.046|-0.034*|
|**tby**|20|0.075|0.062|0.026|0.109|28|0.059|0.039|0.011|0.085|-0.016|-0.023|
|**rrate**|20|0.031|0.021|0.013|0.035|28|0.034|0.027|0.008|0.048|0.004|0.006|
|**(log) gdp**|20|0.480|0.525|0.345|0.629|28|0.545|0.560|0.486|0.650|0.065|0.034|
|**(log) reer**|20|0.089|0.031|0.017|0.143|28|0.034|0.019|0.005|0.050|-0.055**|-0.012*|

Note: Authors’ calculations. * p<0.10, ** p<0.05, *** p<0.01 Several results can be highlighted from Table **3** . First, the contribution of external shocks to GDP volatility is slightly larger in developed economies (at 25%) as compared to developing countries (at 20%). Most of the difference is driven by the predominance of shocks to external

> 4 The responses could also be due to Balassa-Samuelson effects.

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