An Analysis of International Shock Transmission : A Multi-Level Factor Augmented Time-Varying GVAR Approach

We develop and apply a new methodology in order to study the transmission mechanisms of international macroeconomic and financial shocks in the context of emerging markets. We propose a time-varying multi level factor augmented global VAR model which combines aspects of factor analysis and GVAR model by replacing the cross-unit averages that serve as foreign variables in the GVAR model with data driven regional and global factors. The main findings are as follows. First, there is substantial time-variation in the responses of selected emerging countries to various external shocks. Second, in response to tighter global financial conditions, policy rates increase, particularly after the crisis except in Mexico. We find that Turkey and South Korea are more concerned with financial stability and capital inflows given that they increase their short term rates more at the expense of large drops in equity prices and output. Third, financial tightening in other emerging country groups has a loosening effect on the financial conditions particularly in Turkey and Mexico. Fourth, as we include a global financial risk factor along with the US monetary policy rate in our model, the well documented contractionary effects of US interest rate is taken over by the global financial risk shock. Lastly, we find some evidence that macroeconomic interdependencies among emerging economies have been increasing while their dependencies on advanced economies have been decreasing over time