The world is not enough! Monetary policy and regional dependence

A long standing literature has investigated the patterns of globalization and regionalism, and their impact on business cycle synchronization. While earlier studies emphasized the importance of world factors in describing the evolution of domestic business cycles, more recent studies have pointed out that despite the importance of common global forces; the business cycles across the world have not become more synchronized. This could suggest that country specific factors (such as monetary policy) play a major role for business cycles or that clusters of countries/regions are more dependent, i.e. the business cycles in a given region will be synchronized, but across a region, the cycles diverge.

A major challenge when analyzing these issues is how to separate the truly common global factors from the regional factors, while also identifying domestic monetary policy shocks. We address this issue by estimating a three block factor augmented VAR (FAVAR) model with separate world, regional and domestic blocks using two different identification schemes (recursive and sign restrictions). In addition we also explicitly account for domestic and foreign monetary policy.

The analysis is applied to several small and open inflation targeting countries (Canada, New Zealand, Norway and the UK), potentially affected differently by the various regions. Our main results are as follows: The world and the regional shocks explain a major share of business cycles in all countries, although the contribution of the regional shocks varies with the country under study. Yet, the regional factor turns out to be more important than the world factor in explaining the interest rate variance in all countries but the UK. Hence, for some policy makers in small open economies the world is not enough.