Global and domestic financial cycles: variations on a theme

Focus

Interest in financial cycles has increased sharply in recent years. This paper contrasts and compares analytically and empirically two popular notions: the "domestic financial cycle" (DFC) and the "global financial cycle" (GFCy).

Contribution

Despite their popularity, there is considerable ambiguity about the two financial cycle notions. As a result, they are sometimes confused. This paper clarifies the similarities and differences. The starting point is that the DFC focuses on how financial conditions within individual countries lead to boom-bust cycles; the GFCy focuses on how global financial conditions affect individual countries. Analytically, the two concepts have a common basis - the ebbs and flows of financial risk-taking and risk avoidance as reflected in funding conditions and asset prices.

Findings

The GFCy has a similar duration to that of the business cycle as traditionally measured; the DFC is much longer and is closely related to the large, but typically neglected, medium-term fluctuations in output. While DFCs co-move in some instances, they can also be highly asynchronous; the GFCy is, by definition, global. The two cycles come together around crises, when output declines are largest. Traditional GFCy measures mainly reflect developments in advanced economies; a simple alternative measure is much more relevant for emerging market economies.

Abstract

We compare and contrast two prominent notions of financial cycles: a domestic variant, which focuses on how financial conditions within individual economies lead to boom-bust cycles there; and a global variant, which highlights how global financial conditions affect individual economies. The two notions share a common analytical basis - the "procyclicality" of the financial system. Yet a number of distinguishing features stand out. These include differences in: (i) the underlying components - financial asset prices and capital flows for the global financial cycle (GFCy) versus credit and property prices for the domestic financial cycle (DFC); (ii) their empirical properties - the GFCy has a shorter duration and is primarily linked with traditional business cycles, while the DFC has a longer duration and is predominantly linked with medium-term business cycles; and (iii) the policy focus - "dilemma versus trilemma" for the GFCy, "lean versus clean" for the DFC. Despite these differences, the two cycles tend to come together around crises. Finally, we show that traditional GFCy measures mainly reflect developments in advanced economies and that a simple alternative measure is much more relevant for emerging market economies.

JEL classification: F30, F40, E32, E50

Keywords: global financial cycle, financial cycle, business cycle, capital flows