# **1. Introduction**

The main objective of this paper is to provide an exploration into the sources of macroeconomic volatility in the small open developing economies. An important aspect of our study is to contrast the sources of volatility based on a series of country characteristics, such as size, development level, institutional quality, and the incidence of fiscal rules adoption. Such analysis allows us to highlight the key shocks and frictions affecting the small developing countries and provide some insights into the stabilization role of the fiscal policy in these economies.

For this purpose, we construct a data set covering 48 countries, of which 20 are developing and 28 are developed economies, at quarterly frequency during 1960:Q1-2015:Q4 period, and use it to investigate the sources of volatility by means of several methods. We begin by estimating a Structural Vector Autoregression (SVAR) for each country in our sample. This allows us to analyze and quantify the effects of various shocks on GDP in each country. We report the results of these variance decompositions conditional on various country characteristics: size, development level, institutional quality and the presence of fiscal rules.

We find that across all countries, on average, about 22% of the overall GDP volatility is driven by external shocks which include shocks to the world real interest rate (proxied by the US T-bill rate) and to the foreign demand conditions (proxied by the US GDP). The contribution of shocks to each external variable is roughly equal at 11% each. The remaining 78% are accounted for by domestic shocks including shocks to government expenditures, trade balance, real interest rate, real exchange rate and GDP itself. Among domestic factors, shocks to GDP contribute the most to GDP fluctuations (just over 50%), followed by the shocks to government expenditures (10%), trade balance (7%), real exchange rate (6%) and domestic real interest rate (3%).

These decompositions change as we condition on country size, where the latter is measured by average population. Specifically, we find that larger countries are more susceptible to external shocks, as the overall contribution of these shocks to their GDP volatility equals 29%, compared to just 17% in smaller economies. This difference is driven by both shocks to the world interest rate and foreign demand, with the latter being somewhat more important. In terms of the domestic factors, shocks to GDP are more important drivers of GDP volatility in small economies relative to larger countries. For instance, mean contribution of GDP shocks is 58% in small countries, while it is a significantly smaller 46% in large economies. At the same time shocks to the real exchange rate carry a greater importance in larger countries relative to smaller ones. The contributions of all other shocks to GDP volatility are indistinguishable between large and small countries.

Turning to the level of development, we find that the role played by external shocks for GDP volatility is slightly larger in developed economies and that most of the difference is driven by the predominance of shocks to external demand in these economies. Among domestic factors, shocks to GDP are more important drivers of GDP volatility in developed countries relative to developing economies, while the reverse is true for the shocks to government expenditures and the real exchange rate.

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