Global Drivers and Macroeconomic Volatility in EMEs: a Dynamic Factor, General Equilibrium Perspective

We study the role of global drivers in emerging market economies (EMEs)’ business cycles. Using a dynamic factor model, we first pin down the global drivers that are relevant to a sample of twelve EMEs. Our identification assumption allows for the well-known global financial cycle to coexist with additional global factors of different nature, i.e. commodities, growth/productivity. Next, to better understand how these global forces are transmitted into EMEs we zoom in on Chile—one of the EMEs in the sample—and augment a large-scale DSGE regularly used for policy analysis with the estimated global dynamic factor structure. This allows us to document the general equilibrium channels through which shocks in these global factors are transmitted into the business cycle of Chile and, in turn, the policy challenges that they entail. Our findings indicate a preponderant role of global drivers for EMEs’ business cycles, with a third of their macro variability being traced back to shocks in global dynamic factors. While the global financial cycle is a relevant force, a factor associated to global prices and commodities appears equally important, with a relatively modest role played by pure growth/productivity forces. The general equilibrium analysis for Chile reveals that while some of the ensuing effects of shocks to the financial cycle offset each other, the opposite occurs when a shock to global prices materializes, calling for a more active monetary policy response.