Abstract
The study examines the response of financial market stress to innovations in global economic activity and the exchange rate in emerging and advanced market economies during the period 2006Q1 and 2020Q4. This is achieved by means of time series econometric analysis. The impulse response function estimated through structural factorization indicates that financial market stress responds positively towards its own innovations and to innovations in global economic activity. In contrast, financial market stress responds negatively to a one standard deviation in the exchange rate in the long run albeit the response is neutral in the short run. The findings from the variance decomposition show that in advanced market economies, a larger fraction of the discrepancies in financial market stress are explained by its own innovations followed by innovations in global economic activity, whereas in emerging market economies, a larger proportion of the discrepancies in financial market stress are explained by its own innovations followed by innovations in the broad exchange rate. Given the findings, the study recommends strong coordination between monetary policy and fiscal policy to ensure that overall economic activity is optimized and maintained in the long run. Monetary authorities have a role to play in ensuring price and exchange rate stability while fiscal authorities have the tools to realize minimal budget deficits and optimal debt management.
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