The Importance of Global Shocks for National Policymakers: Rising Challenges for Central Banks

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3. Data and variables

In our FAVAR analysis, we use quarterly time series from Q1 1984 to Q4 2007 for the
G7-countries plus the euro area, i.e. the US, Japan, the UK and Canada and the EMU.
Hence, 48.9% of global GDP in 2007 is represented in our empirical analysis.⁴ In
principle, one could argue that emerging markets have become increasingly important for
the global economy and international financial markets. However, we opted for a focus
on major industrialized countries for three reasons. First, the majority of emerging
markets have a fixed exchange rate regime which makes monetary spillover effect likely,
according to the traditional trilemma view. The motivation of our study is to examine
whether such monetary spillovers can also occur despite flexible exchange rates. Second,
there are data availability problems even for bigger emerging markets. Third, as already
mentioned in section 2, common components appear to play a larger role in business
cycles in advanced economies than in emerging market economies, where country-
specific factors tend to be more important.

Why are global liquidity shocks important in our context and by far no artifact?
Some critics might argue that global liquidity, as measured in one currency, can only
change in quantitative terms if one assumes a fixed exchange rate system worldwide.
Note, however, that international liquidity spillover effects may occur regardless of the
exchange rate system. Under pegged exchange rate regimes, official foreign exchange
interventions result in a transmission of monetary policy shocks from one country to
another. In a system of flexible exchange rates, the validity of the "uncovered interest rate
parity" (UIP) relationship should in theory prevent cross-border monetary spillover.
According to this theory, the expected appreciation of the low-yielding currency in terms
of the high-yielding currency should be equal to the difference between (risk-adjusted)
interest rates in the two economies.

However, the violation of the UIP - often referred to as the “forward premium
puzzle”- is a common empirical finding in the literature on macroeconomics and finance.
The enduring existence of carry trades can be taken as evidence that exchange rates
diverge from fundamentals for lengthy periods, as the exposure of a carry trade position

⁴ Own calculations based on IMF PPP data.

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