The Transmission of Foreign Interest Rate Shocks to a Small-Open Economy: The Role of External Debt and Financial Integration

This paper investigates the implications of external indebtedness and international -nancial integration on the e¤ects of foreign interest rate shocks in a small-open economy. The theoretical component of the analysis develops a business cycle model that can suc-cessfully match the impulse responses of the Turkish economy to U.S. interest rate shocks. It is found in the context of this model that the relationship between \u85nancial integration and macroeconomic volatility due to foreign interest rate shocks depends on the level of out-standing external debt. Financial integration mitigates the economys responses to foreign rate shocks for higher levels of external debt. It magni\u85es the economys responses for lower levels of external debt. The model is estimated on quarterly Turkish data. The estimated version reveals that the Turkish Economys responses to U.S. interest rate shocks would be signi cantly less pronounced for lower levels of external debt. JEL classi\u85cation: E30; F36; F4