The Transmission of U.S. Monetary Policy to Small Open Economies

This paper studies the transmission of U.S. monetary policy tightening shocks to a set of advanced and emerging-market small open economies. It applies Forni et al (2009) Structural Factor-augmented Vector autoregression model to a database comprising the period 2001Q4-2022Q2. The paper contributes to the literature on the international transmission of U.S. monetary policy by distinguishing between monetary policy shocks using as instruments Wu and Xia shadow rate, the Fed Funds rate and changes in the Fed balance sheet, as well as by studying various international transmission channels. The main findings, with significant policy implications, are the following: (1) the relative importance of the different international monetary policy transmission channels is contingent on whether the monetary policy tightening results from a conventional or an unconventional monetary policy shock. (2) While after the global financial crisis the domestic effects of a U.S. monetary policy tightening have only changed regarding its effects on the balance of payments behavior, its international transmission via the financial channel has become more important. (3) A U.S. monetary policy tightening always reduces foreign economic activity and long-term interest rates. (4) It contributes to the emergence of a “global” financial cycle that depresses economic activity. (5) Besides the degree of countries’ trade openness, differences in the shock transmission across countries do not seem to depend on the different degrees of exchange rate floating or financial openness. (6) There is evidence of an oil price transmission channel that is independent of the type of U.S. monetary policy shock. (7) Monetary policymakers in small open economies react to the macroeconomic effects of U.S. monetary policy shocks