Global financial risk, aggregate fluctuations, and unemployment dynamics

Abstract

We use a panel structural vector autoregression methodology to study the impact of global financial risk shocks in emerging market economies (EMEs) versus small open advanced economies (SOAEs). The short-term responses of GDP, investment, and un- employment are similar in EMEs compared to SOAEs, but their medium-term responses differ considerably. In EMEs the shock propagates less across GDP and investment, and the response of unemployment is prominently more subdued. Further analysis suggests that while in EMEs these dynamics can be traced back to the response of country interest rates to global financial risk shocks and to the average degree of firm informality, in SOAEs these factors are not at play. Instead, for SOAEs the dynamics of bank credit can matter to some degree, but more broadly a global financial risk shock passes through more directly into the economy.