Modelling External Shocks in a Small Open Economy: The Case of Ireland

The Irish economy has recovered at an impressive pace from the economic and financial crisis that lasted from 2008-2012. Based on a measure of underlying domestic demand, the economy has grown at an average annual rate of just... [ view full abstract ]

The Irish economy has recovered at an impressive pace from the economic and financial crisis that lasted from 2008-2012. Based on a measure of underlying domestic demand, the economy has grown at an average annual rate of just over 5 per cent since 2013, and current projections for the medium-term outlook are favourable. Nonetheless, as a small open economy with some lingering vulnerabilities from the recent crisis, the economy remains heavily exposed to potential adverse shocks. In this paper, we quantify the possible impact on the Irish economy of a number of potential adverse shocks. We model the shocks in a two-stage process: first using a global model to estimate the impact on Ireland’s trading partners and the broader international environment and then examining the effect of these changes in a model of the Irish economy. The paper focusses on three relevant risks facing the economy: the potential for a hard Brexit, a depreciation of the sterling euro exchange rate and an increase in ECB interest rates. Using this two-step approach allows us to demonstrate – in a fully consistent manner – the transmission of external shocks to the Irish economy. Our results show that a hard Brexit scenario could reduce the level of output by around 3.2 per cent after 10 years. While the other shocks would have a less severe impact on output, the results help to quantify the potential impact on future growth, the labour market, public finances and the banking system in the event of some key risks materialising.