Deriving Forces of Macroeconomic Instability: A Case of Developing Nations

Abstract

The purpose of this study is to investigate empirically the role of internal and external shock in macro-economic fluctuations. This study used quarter data for internal, monetary policy, fiscal policy, and external shocks, foreign direct investment, foreign aid, trade openness, from world development indicator for 56 developing countries over the period of 1960Q1 - 2013Q4. Study employed Vector Error Correction Model (VECM) to assess long run relationship between internal and external shocks and macroeconomic instability. Moreover, study employed variance decomposition and impulse response function to assess the relative importance of internal and external shocks and to forecast the response of macroeconomic fluctuation in time t + n when one standard positive or negative shock is given to VAR system of internal and external sources at time t while no other shock hits the system in developing nations. The results show that fiscal policy causes to amplify the macroeconomic fluctuation while monetary policy causes to dampen them. Moreover, external factors FDI and trade openness positively and significantly affect economic fluctuations while official development assistance negatively and significantly affects economic fluctuations. The results indicate that in developing countries combination of internal and external policies are required to stabilize the economic fluctuation. Study helps the policy maker to formulate appropriate policies to stabilize the economic activities.