Finance and Economics Discussion Series (FEDS)
July 2016
Financial Vulnerabilities, Macroeconomic Dynamics, and Monetary Policy
David Aikman, Andreas Lehnert, Nellie Liang, and Michele Modugno
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, credit, monetary policy
DOI: http://dx.doi.org/10.17016/FEDS.2016.055
PDF: Full Paper