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

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We conclude that common forces exist which qualify as global factors in the
global economy and on international financial markets. The seven global factors are
therefore used for estimating a SFAVAR in levels including a constant and a time trend.⁵
Since the global factors have been obtained in first-differences, they are "re-constructed"
in levels by setting each global factor equal to zero in the first quarter of 1984 and
calculating the cumulative sum of the first principal components. In order to identify the
global structural shocks, the following assumptions are made:

with η as the vector of errors in the reduced-form equations and u as the global
structural shocks. The global GDP (YR) and the global house price factor (HP) are not
influenced contemporaneously by any other global variable. The global inflation factor
(PI) is affected contemporaneously only by the commodity price factor (CP). The latter is
affected at the same time by all other common factors apart from inflation. The global
money factor is influenced contemporaneously by the global GDP and inflation factor
and by the short-term interest rate (SR) as well. For the reaction function of central banks'
worldwide, it is assumed that they react contemporaneously to commodity prices, the
global house price factor and global money, but not to the global activity and inflation
factor due to time lags in publication. Given the forward-looking nature of financial
markets, share prices (SP) respond to all other global variables at the same time.

To determine the lag length, we apply the usual criteria such as the Likelihood
Ratio test, the Final Prediction Error, the Akaike information criterion, the Schwarz
criterion and the Hannan-Quinn criterion. Most of the criteria point at a lag length of two,
which is also sufficient to avoid serial correlation among the residuals and seems to be

⁵ Since we now impose some structure on the global economy, we introduce the notion of a SFAVAR
instead that of a pure FAVAR analysis.

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