Working Paper: CEPR ID: DP16203
Authors: Christian Friedrich; Pierre Guerin; Danilo Leiva Leon
Abstract: We propose a new strength measure of the global financial cycle by estimating a regime-switching factor model on cross-border equity flows. We then assess how this measure affects monetary policy independence, defined as central banks' responses to exogenous changes in inflation. We show that central banks tighten their policy rates in response to an unanticipated increase in inflation during times when global financial cycle strength is low, but their responses are muted when financial cycle strength is high. Finally, we show that capital controls, macroprudential policies, and a flexible exchange rate regime can increase monetary policy independence.
Keywords: global financial cycle; strength; monetary policy independence; capital controls; macroprudential policies
JEL Codes: F32; E4; E5; G15; F42; G18
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| low global financial cycle strength (F65) | increase in policy rates (E43) |
| high global financial cycle strength (F65) | muted increase in policy rates (E52) |
| capital controls, macroprudential policies, and flexible exchange rate (F38) | increase in monetary policy independence (E58) |
| global financial cycle strength (F65) | monetary policy responses (E52) |