Global financial markets are tightly connected, and shocks in one part of the world can quickly affect national economies. A new study shows that global financial risk is not only a major driver of economic fluctuations in small open economies, but also complicates how we measure the effects of monetary policy.
In the paper Global Risk Shocks in a Small Open Economy and Their Impact on Monetary Policy Surprises, Juan Michelsen (Technische Universität Berlin and Berlin School of Economics) asks two key questions: How do sudden increases in global financial risk affect the Canadian economy? And do these global shocks distort common measures of monetary policy decisions?
The study focuses on Canada as an example of a small open economy – an economy that is strongly connected to global trade and financial markets but too small to influence global conditions itself. This makes Canada a useful case for studying how external financial shocks affect domestic economic activity.
To answer these questions, the researcher develops a new way to measure global risk shocks. The approach is based on unexpected daily changes in the VIX, a widely used financial market indicator that reflects expected stock market volatility and is often described as a “fear index”. By isolating the unexpected component, the study captures sudden shifts in global risk sentiment rather than predictable market movements.
These high-frequency risk surprises are then combined with monthly Canadian economic data from 2002 to 2019. The analysis includes indicators such as GDP, inflation, interest rates, exchange rates, credit spreads (the difference between risky and safe borrowing costs), and stock prices. The method used – a proxy structural vector autoregression, or proxy-SVAR – is an econometric model designed to identify cause-and-effect relationships between shocks and economic outcomes over time.
Global risk shocks have significant effects on the Canadian economy
The results show that global risk shocks have broad and significant effects on the Canadian economy. When global risk rises unexpectedly, the Canadian dollar depreciates against the U.S. dollar, financial conditions tighten, and stock prices fall. At the same time, economic activity slows and consumer prices decline.
Monetary policy responds to these developments. The central bank tends to adopt a more expansionary stance, meaning that interest rates move lower than they otherwise would in order to support the economy. Overall, the findings show that global financial risk is a powerful external force shaping both financial markets and real economic activity.
The study also highlights an important measurement problem. Economists often use high-frequency “monetary policy surprises” to estimate the effects of central bank decisions. These measures capture the difference between what markets expected and what the central bank actually did at the time of policy announcements.
However, the analysis shows that these surprise measures partly reflect changes in global risk rather than purely independent policy decisions. When global risk increases between policy meetings, central banks may adjust their decisions accordingly. At the same time, financial markets may misjudge how strongly the central bank will respond. As a result, the measured “surprise” combines genuine policy changes with risk-driven market reactions.
Once the global risk component is removed from these measures, the estimated effects of monetary policy become smaller and more consistent with standard economic theory. In particular, financial variables react less strongly, while exchange rate movements become clearer. This suggests that traditional approaches may overstate the real economic impact of monetary policy if global risk is not taken into account.
Global financial conditions matter greatly for small open economies
The broader message of the study is that global financial conditions matter greatly for small open economies. External risk shocks can influence exchange rates, borrowing costs, asset prices, and economic growth, even when domestic conditions are stable. For policymakers, this highlights the importance of monitoring global financial developments alongside domestic indicators.
For researchers and central banks, the findings also underline the need for careful measurement. Accurately separating global financial shocks from domestic policy actions is essential for understanding how monetary policy works and for designing effective responses in an interconnected financial system.
As global financial cycles continue to shape national economies, this research provides a practical framework for identifying and accounting for external risk. Understanding these forces is crucial for making informed policy decisions in an increasingly integrated world.
About the Author
Juan Michelsen
Juan Michelsen is a PhD student in Economics at Technische Universität Berlin and the Berlin School of Economics and a research assistant at Technische Universität Berlin. His research focuses on empirical macroeconomics, particularly risk and monetary policy shocks.
