The transmission of international shocks to the UK. Estimates based on a time-varying factor augmented VAR

• We estimate an open economy factor-augmented VAR model with time-varying parameter.
• We investigate how the impact of external shocks on the UK has changed over time.
• Before the 1990s, UK real activity was positively affected by increases in foreign interest rates.
• This relationship has become weaker in the recent past.
• International aggregate demand shocks play an important role during the recent recession.

The aim of this paper is to gauge the importance of foreign demand, supply and interest rate shocks on the UK economy and assess how their role has changed over time. To that end we devise a time-varying factor augmented VAR model that captures the relationship between 17 industrialised countries and the UK and accounts for any temporal evolution in this relationship. The response of UK macroeconomic variables to a foreign interest rate shock is estimated to have changed significantly since the early 1990s. International demand shocks play an important role in driving World and UK real activity, especially during the recent recession.