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Melting Down: Systemic Financial Instability and the Macroeconomy

41 Pages Posted: 6 Jul 2014 Last revised: 5 Mar 2015

Philipp Hartmann

European Central Bank (ECB); Centre for Economic Policy Research (CEPR) - International Macroeconomics

Kirstin Hubrich

Board of Governors of the Federal Reserve System

Manfred Kremer

European Central Bank (ECB)

Robert J. Tetlow

Federal Reserve Board

Date Written: February 28, 2015

Abstract

We investigate the role of systemic financial instability in an empirical macrofinancial model for the euro area, employing a richly specified Markov-Switching Vector Autoregression model to capture the dynamic relationships between a set of core macroeconomic variables and a novel indicator of systemic financial stress. We find that at times of widespread financial instability the macroeconomy functions fundamentally differently from tranquil times. Not only the variances of the shocks, but also the parameters that capture the transmission of shocks change regime, especially around times of high systemic stress in the financial system. In particular, financial shocks are larger and their e¤ects on real activity propagate much more strongly during high systemic-stress regimes than during tranquil times. We find an economically important role of lending in the propagation of financial stress to the macroeconomy. We also show that prospects for detecting high systemic stress episodes appear promising, although we argue that more research is required. We conclude that macroprudential policy makers are well advised to take these non-linearities into account.

Keywords: financial stability, systemic risk, macro-financial linkages, Markov switching VAR, non-linearities

JEL Classification: E44, C11, C32

Suggested Citation

Hartmann, Philipp and Hubrich, Kirstin and Kremer, Manfred and Tetlow, Robert J., Melting Down: Systemic Financial Instability and the Macroeconomy (February 28, 2015). Available at SSRN: https://ssrn.com/abstract=2462567 or http://dx.doi.org/10.2139/ssrn.2462567

Philipp Hartmann

European Central Bank (ECB) ( email )

Sonnemannstrasse 22
Frankfurt am Main, 60314
Germany
(49 69) 1344 7356 (Phone)
(49 69) 1344 8553 (Fax)

Centre for Economic Policy Research (CEPR) - International Macroeconomics

77 Bastwick Street
London, EC1V 3PZ
United Kingdom

Kirstin Hubrich (Contact Author)

Board of Governors of the Federal Reserve System ( email )

20th Street and Constitution Avenue NW
Washington, DC 20551
United States

Manfred Kremer

European Central Bank (ECB) ( email )

Sonnemannstrasse 22
Frankfurt am Main, 60314
Germany
+49 69 1344 7065 (Phone)

Robert J. Tetlow

Federal Reserve Board ( email )

20th and C Streets, NW
Washington, DC 20551
United States

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