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

Abstract

We develop and apply a new methodology to study the transmission mechanisms of international
macroeconomic and financial shocks in the context of emerging markets. Our approach combines
aspects of factor analysis and GVAR models by replacing the cross-unit averages that serve as
foreign variables in the GVAR model with macroeconomic and financial factors extracted hierarchically from unbalanced panels of country-level data. Furthermore, we allow for time variation in both the model parameters and shock volatility. Our key empirical findings are as follows. First, we find that the macroeconomic conditions in the emerging economies under consideration became more sensitive to global financial conditions during and after the recent financial crisis. Moreover, they appear more concerned with financial stability as they do not try to offset the contractionary effects of tightening in global financial conditions by decreasing their policy rates. Second, deterioration of financial conditions in other emerging market country groups has a loosening effect on domestic financial conditions. Third, as we include a global financial risk factor along with the US monetary policy rate, our results suggest that the contractionary effects of US interest rate shocks are 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.

Keywords: Time-varying parameter GVAR model, Factor analysis, Dual Kalman Filter, Transmission channels of external shocks

JEL Classification: C30, C32, C38, E44, F41