Heaven or Earth? The Evolving Role of Global Shocks for Domestic Monetary Policy

Business cycles are increasingly driven by global shocks, rather than the domestic demand shocks prominent in earlier decades, posing challenges for central banks seeking to meet domestic mandates and communicate their policy decisions. This paper analyzes the evolving influence and characteristics of global and domestic shocks in advanced economies from 1970-2024 using a new FAVAR model that decomposes movements in interest rates, inflation, and output growth into four global shocks (demand, supply, oil, and monetary policy) and three domestic shocks (demand, supply, and monetary policy). We find that the role of global shocks has increased sharply over time and that their characteristics differ from those of domestic shocks across multiple dimensions. Compared to domestic shocks, global shocks have a larger supply component, higher variance, more persistent effects on inflation, and are more asymmetric (contributing more to tightening than to easing phases of monetary policy). As global supply shocks have become more prominent, central banks have also been less willing to “look through” their effects on inflation than for comparable domestic shocks. The distinct characteristics and rising influence of global shocks—particularly global supply shocks—have significant implications for modeling monetary policy and designing central bank frameworks.