Measuring the Effects of the ‘Normalization’ of US Monetary Policy on Central America and the Dominican Republic

Since the beginning of the international financial crisis in major developed economies, central banks of these countries implemented several monetary policy (MP) measures, oriented to stabilize the financial system and mitigate the effects on the real side of the economy. As more data on the recovery of US economy becomes available, the speech of FED authorities is turning to consider the rising of the FED fund rates (FFR), defined as “normalization”. The effects of the US MP normalization are unclear – mainly for economies with low degrees of financial development – since the reversion of a monetary policy to a pre-crisis stance would take place under a US growth scenario. We estimate the impact of the normalization on Central America and the Dominican economies, summarizing the information of nearly 80 variables in a few common factors and considering both effects through real and financial channels. We estimate a factor augmented VAR, to measure the impact of US MP shocks to these economies, using a sign restriction approach in the identification process of such shocks. Then we use measured shocks to map the effects on domestic variables. Our results indicate that this eventuality will affect these economies mostly through its effects on the real side of the economy due to its impact on external demand and the reduced role of exchange rate as a shock absorber, where countries with less flexible exchange rate regimes being more affected. On the financial side, domestic interest rate will rise and net international reserves will fall, as central banks limit volatility in exchange rates.