**4.2 Impulse responses**

The impulse response function will tell us the change in endogenous variables for each structural shock at t, t + 1, and so on. Our goal is to trace out the effects of internal shocks to the WB 6 economies. First, we employ Sims' (1980) orthogonalized impulse response functions [42]. We will trace out the responses of the dependent variables in the SVAR models to shocks.

The response of gdp\_gap, in **Figure 2**, to the economic freedom shock, keeps increasing until the 19th month, up to 0.252388. As the economy is hit by the economic freedom shock, productivity increases for the first 6 months and then stops for a while till expectations of the market get to equilibrium and get positive perspective. Domestic investments increase until the 19th month. Closely, we must keep our eyes

**AL B&H KS MNE NM SRB**

RMSE 0.609466 0.471552 0.569857 0.623307 0.891088 1.618317 MAE 0.562789 0.365514 0.481942 0.558959 0.72649 1.353392 MAPE 192.5031 10.31633 10.45501 20.31178 1.223044 307.8459 Theil 0.404218 0.067415 0.066878 0.090758 0.007274 0.258264

*Governance and Growth in the Western Balkans: A SVAR Approach*

*DOI: http://dx.doi.org/10.5772/intechopen.91731*

We observe from **Figure 2** the response of GDP and inflation to the government efficiency shock. The response of AL GDP to GOVEFF shocks slightly decreases in the first quarter and afterwards continues with the same impulse. Moreover, the response of AL INF to GOVEFF shocks increases in the first two quarters and after that has no impact. Why? Moving to Bosnia and Hercegovina, we notice that the response of GDP to government efficiency shocks is positive. The GDP increases in the first 6 months then drops down until the end of the fourth quarter, while inflation increases from 0.15 to 0.23 from the first to the second month, respectively. Interestingly, inflation drops to 0.06 in the fifth month. In the second year, the shocks persist in lowering inflation (deflation) to 0.34. In the case of Kosovo, government efficiency shocks decrease GDP in the first two quarters to 0.19 and then keep mounting slowly till the 19th month, reaching 0. The response of inflation to the shock is that it increases just slightly until the 2nd month, following with

We have to take into consideration the role of expectations in explaining the impact of government efficiency shocks on GDP and inflation. As the economic government efficiency shock hits the economy, the productivity decreases for the first 10 months and then stops for a while till expectations of the market get to equilibrium and get a positive perspective. Domestic investments increase until the 19th month. Firmly, we must keep our eyes at how expectations of productivity and the labor market are formed. We observe from this case that the response of inflation to the shock immediately starts to decline after the second month, especially in the first year. Afterwards, it starts slowly to increase. Moreover, only after 23 months, it reaches the closest point to zero: 0.02. How can we interpret the above results? Having the good news that the region is moving ahead, towards the EU integrations, having positive expectations, and seeing everyday reforms within the economic activities in the real market, it is to be expected from a reasonable society to have a better perspective. This implies a correction of price expectations *P<sup>e</sup>* in

In the case of Montenegro, the GDP drops down in the first three quarters, reaching 0.28. Additionally, from the third quarter to the end of the 2nd year, the GDP keeps mounting. Inflation responds to the shock of government efficiency with an increase from 0 to 0.2 for the first 11 months. Why? How can we interpret the response of inflation to government efficiency shock? The enhancement of government efficiency changes the quality of the Montenegrin economy.

at how expectations of productivity and the labor market are formed.

a decrease until the 12th month, reaching deflation 0.47.

relation to the current price level *P*.

**227**

*Source: Authors' calculation.*

*GDP forecast measures.*

**Table 4.**


#### *Governance and Growth in the Western Balkans: A SVAR Approach DOI: http://dx.doi.org/10.5772/intechopen.91731*

#### **Table 4.**

*GDP forecast measures.*

The response of gdp\_gap, in **Figure 2**, to the economic freedom shock, keeps increasing until the 19th month, up to 0.252388. As the economy is hit by the economic freedom shock, productivity increases for the first 6 months and then stops for a while till expectations of the market get to equilibrium and get positive perspective. Domestic investments increase until the 19th month. Closely, we must keep our eyes at how expectations of productivity and the labor market are formed.

We observe from **Figure 2** the response of GDP and inflation to the government efficiency shock. The response of AL GDP to GOVEFF shocks slightly decreases in the first quarter and afterwards continues with the same impulse. Moreover, the response of AL INF to GOVEFF shocks increases in the first two quarters and after that has no impact. Why? Moving to Bosnia and Hercegovina, we notice that the response of GDP to government efficiency shocks is positive. The GDP increases in the first 6 months then drops down until the end of the fourth quarter, while inflation increases from 0.15 to 0.23 from the first to the second month, respectively. Interestingly, inflation drops to 0.06 in the fifth month. In the second year, the shocks persist in lowering inflation (deflation) to 0.34. In the case of Kosovo, government efficiency shocks decrease GDP in the first two quarters to 0.19 and then keep mounting slowly till the 19th month, reaching 0. The response of inflation to the shock is that it increases just slightly until the 2nd month, following with a decrease until the 12th month, reaching deflation 0.47.

We have to take into consideration the role of expectations in explaining the impact of government efficiency shocks on GDP and inflation. As the economic government efficiency shock hits the economy, the productivity decreases for the first 10 months and then stops for a while till expectations of the market get to equilibrium and get a positive perspective. Domestic investments increase until the 19th month. Firmly, we must keep our eyes at how expectations of productivity and the labor market are formed. We observe from this case that the response of inflation to the shock immediately starts to decline after the second month, especially in the first year. Afterwards, it starts slowly to increase. Moreover, only after 23 months, it reaches the closest point to zero: 0.02. How can we interpret the above results? Having the good news that the region is moving ahead, towards the EU integrations, having positive expectations, and seeing everyday reforms within the economic activities in the real market, it is to be expected from a reasonable society to have a better perspective. This implies a correction of price expectations *P<sup>e</sup>* in relation to the current price level *P*.

In the case of Montenegro, the GDP drops down in the first three quarters, reaching 0.28. Additionally, from the third quarter to the end of the 2nd year, the GDP keeps mounting. Inflation responds to the shock of government efficiency with an increase from 0 to 0.2 for the first 11 months. Why? How can we interpret the response of inflation to government efficiency shock? The enhancement of government efficiency changes the quality of the Montenegrin economy.

**Figure 1.**

**226**

*GDP\_GAP and inflation stochastic-static solution model simulator. Source: Authors' calculation.*

*Linear and Non-Linear Financial Econometrics - Theory and Practice*

In the case of North Macedonia, the response of GDP to GOVEFF is positive from the very start, increasing the GDP to 0.72 until the 7th month. Afterwards, it falls to 0.12 after the 11th month. The inflation response is positive, reaching 0.32 until the 7th month, then drops down. This might be a piece of vital information for

The response of Serbia GDP to the government efficiency shock is positive. It starts mounting until the second quarter to 0.11 and then keeps decreasing until the 22nd month, reaching 0.17. Again, the mechanism of expectations is crucial in explaining the responses of GDP and inflation in the case of Serbia. This process, in this case, shifts the wage-setting relation, *WS*, to the right less than the PS, increasing employment and GDP. Workers' expectations are not higher than what firms expect, as a result of an increase in government efficiency. Thus, the wage-setting relation (*WS)* will shift less than the price-setting relationship (*PS*). This will decrease unemployment. As we can notice from Figure, inflation automatically starts to fall. The adjustment mechanism, in the case of Serbia, is very well set up

Given the strategic priority the government of Albania, Bosnia and Hercegovina,

Kosovo, Montenegro, North Macedonia, and Serbia have to join the European Union, we felt compelled to identify an approach and methodology that the Governments of the WB 6 can use in developing anti-inflation macroeconomic stability and overall development strategy. Given the high increase in the interest of fulfilling the Maastricht convergence criteria before the accession and the lack of any uniform methodology, we believe that the findings presented in our paper will appeal to macroprudential policymakers. Although previous research papers have identified a few methods that could be used in forecasting growth, such as internal and external variables, the methodologies developed from those findings have been restricted and difficult to administer on a national level of the WB 6. Thus, our findings will allow the macroprudential policymakers to understand the factors involved in identifying the onset of macroeconomic efficiency dynamics and macroeconomic expectations in Western Balkan countries better and develop more effective policy measures that can be used nationally. In so doing, we hope that our research paper advances the toolset needed to combat the growth concerns of many macroprudential policymakers in the Western Balkan countries, especially the

This paper reveals a significantly wider knowledge gap: both theoretical and empirical. We identified recursively six SVAR models. Each model aggregates two critical macroeconomic variables to forecast GDP in the Western Balkans. We find that among the performance of the individual-predictor forecasts, all country models perform with high precision, based on the root mean square error and stochastic-static solution model simulator. This essential evidence shows that government efficiency and inflation are critical in promoting sustainable growth. The main implications of this study suggest that the government efficiency indicator is crucial in governing macroeconomic stability and sustainable growth in Western

The impulse response findings reveal that the responses of GDP and inflation to

a shock on economic governance are significant, except in the case of Albania, where the response of GDP and inflation are almost flat. Future papers are

the macroprudential policymakers of North Macedonia.

*Governance and Growth in the Western Balkans: A SVAR Approach*

*DOI: http://dx.doi.org/10.5772/intechopen.91731*

between the workers and firms.

**5. Conclusions**

Central Banks.

Balkans.

**229**

**Figure 2.** *Impulse responses to economic freedom and EGDI shocks. Source: Authors' calculation.*

*Governance and Growth in the Western Balkans: A SVAR Approach DOI: http://dx.doi.org/10.5772/intechopen.91731*

In the case of North Macedonia, the response of GDP to GOVEFF is positive from the very start, increasing the GDP to 0.72 until the 7th month. Afterwards, it falls to 0.12 after the 11th month. The inflation response is positive, reaching 0.32 until the 7th month, then drops down. This might be a piece of vital information for the macroprudential policymakers of North Macedonia.

The response of Serbia GDP to the government efficiency shock is positive. It starts mounting until the second quarter to 0.11 and then keeps decreasing until the 22nd month, reaching 0.17. Again, the mechanism of expectations is crucial in explaining the responses of GDP and inflation in the case of Serbia. This process, in this case, shifts the wage-setting relation, *WS*, to the right less than the PS, increasing employment and GDP. Workers' expectations are not higher than what firms expect, as a result of an increase in government efficiency. Thus, the wage-setting relation (*WS)* will shift less than the price-setting relationship (*PS*). This will decrease unemployment. As we can notice from Figure, inflation automatically starts to fall. The adjustment mechanism, in the case of Serbia, is very well set up between the workers and firms.
