Financial Vulnerabilities, Macroeconomic Dynamics, and Monetary Policy

David Aikman (), Andreas Lehnert (), J. Nellie Liang () and Michele Modugno
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J. Nellie Liang: https://www.brookings.edu/experts/nellie-liang/

No 2016-055, Finance and Economics Discussion Series from Board of Governors of the Federal Reserve System (U.S.)

Abstract: We define a measure to be a financial vulnerability if, in a VAR framework that allows for nonlinearities, an impulse to the measure leads to an economic contraction. We evaluate alternative macrofinancial imbalances as vulnerabilities: nonfinancial sector credit, risk appetite of financial market participants, and the leverage and short-term funding of financial firms. We find that nonfinancial credit is a vulnerability: impulses to the credit-to-GDP gap when it is high leads to a recession. Risk appetite leads to an economic expansion in the near-term, but also higher credit and a recession in later years, suggesting an intertemporal tradeoff. Monetary policy is generally ineffective at slowing the economy once the credit-to-GDP gap is high, suggesting important benefits from avoiding excessive credit growth. Financial sector leverage and short-term funding do not lead directly to contractions and thus are not vulnerabilities by our definition.

Keywords: Financial stability and risk; Monetary policy; Credit (search for similar items in EconPapers)
JEL-codes: E58 E65 G28 (search for similar items in EconPapers)
Pages: 53 pages
Date: 2016-07-07
New Economics Papers: this item is included in nep-mac and nep-mon
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Citations: View citations in EconPapers (11)

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Persistent link: https://EconPapers.repec.org/RePEc:fip:fedgfe:2016-55

DOI: 10.17016/FEDS.2016.055

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