Monetary Cycles, Financial Cycles and the Business Cycle
Federal Reserve Bank of New York
Rensselaer Polytechnic Institute
Hyun Song Shin
Bank for International Settlements; Princeton University - Department of Economics
January 1, 2010
FRB of New York Staff Report No. 421
One of the most robust stylized facts in macroeconomics is the forecasting power of the term spread for future real activity. The economic rationale for this forecasting power usually appeals to expectations of future interest rates, which affect the slope of the term structure. In this paper, we propose a possible causal mechanism for the forecasting power of the term spread, deriving from the balance sheet management of financial intermediaries. When monetary tightening is associated with a flattening of the term spread, it reduces net interest margin, which in turn makes lending less profitable, leading to a contraction in the supply of credit. We provide empirical support for this hypothesis, thereby linking monetary cycles, financial cycles, and the business cycle.
Number of Pages in PDF File: 19
Keywords: monetary policy, financial intermediation
JEL Classification: E52, E50, E44, G18
Date posted: January 6, 2010
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