Financial Cycle, Stress, and Policy Roles in Small Open Economy: Spillover Index Approach

This chapter analyzes the dynamic spillover of shocks between selected macroeconomic and financial variables in the case of a small open economy. To evaluate the effects of macroprudential policy, alongside its interaction with the fiscal and monetary policy, a spillover methodology approach was made as an extension to the VAR (vector autoregression) modeling. Such methodology enables the researcher and policymakers a dynamic approach of modeling, with detailed insights into the sources of time-varying variability of variable interconnection. Based on quarterly data from 4Q 1995 to 4Q 2021 for the case of Croatia, this chapter analyzes the interactions and shock spillovers between the financial stress, credit, real activity, inflation, macroprudential and fiscal policy, with exogenous variables of the Eurozone monetary policy and its real activity. The approach of this study enables macroprudential policymakers to make decisions promptly, and the decisions could be adjusted based on the interactions between the financial system and the real economy. Furthermore, as findings indicate that macroprudential, monetary, and fiscal policies are not isolated, their interactions and transmission channels affect individual policy effectiveness and spillover from one goal to the other. Therefore, future tailoring of all policies needs to be based on such findings and trying to achieve complementarity with them. Although this is a difficult task, just admitting that such interactions exist eases the later modeling and fine-tuning of all instruments.