Debt Deflation, Financial Market Stress and Regime Change – Evidence from Europe Using MRVAR

40 Pages Posted: 18 Apr 2016

See all articles by Ekkehard Ernst

Ekkehard Ernst

International Labour Organization (ILO)

Willi Semmler

The New School - Department of Economics; Universitaet Bielefeld; IIASA

Alexander Haider

The New School - Department of Economics

Date Written: February 28, 2016

Abstract

The economic meltdown since 2008-9 has created disinflation, and even deflation in some countries in the Euro-area, in a period with large debt overhang, creating the condition for a continuing financial market stress in the Euro-area. As disinflation and deflation push up the real interest rate, while growth and income declines, the leveraging problem becomes more severe and the economy risks shifting into a regime with high insolvency risk, high financial stress, rising credit spreads, possibly accompanied by strong adverse macroeconomic feedback loops. Investigating the consequences of those magnifying feedback loops, given the debt deflation, we demonstrate the possibility of unstable dynamics and downward spirals in the presence of regime-dependent macro feedback loops, using a theoretical model with decentralized matching mechanisms on both labor and financial markets. To explore the amplifying linkages between deflation, output, labor and financial markets, we employ a new solution procedure called NMPC to solve our models variants for out-of-steady-state dynamics. We empirically explore deflationary trends in Europe and employ a Global VAR (GVAR) model for a large euro area macro data set to estimate the impact of deflation on output. Moreover, we use a four variable Multi-Regime VAR (MRVAR) model with regime dependent IRs to study deflationary as well as well as the financial risk drivers in a MRVAR setting. New measures for financial risk drivers are employed and multi-regime IRs for output, inflation rates, interest rates and financial stress are explored. We also study regime changes in central macro relationships such as regime change in the credit - output link, the Phillips curve and in Okun’s law.

Suggested Citation

Ernst, Ekkehard and Semmler, Willi and Haider, Alexander, Debt Deflation, Financial Market Stress and Regime Change – Evidence from Europe Using MRVAR (February 28, 2016). ZEW - Centre for European Economic Research Discussion Paper No. 16-030. Available at SSRN: https://ssrn.com/abstract=2765411 or http://dx.doi.org/10.2139/ssrn.2765411

Ekkehard Ernst

International Labour Organization (ILO) ( email )

Route des Morillons 4
Geneva, 1211
Switzerland
+41 22 799 77 91 (Phone)

Willi Semmler (Contact Author)

The New School - Department of Economics ( email )

65 Fifth Avenue
New York, NY 10003
United States

HOME PAGE: http://www.newschool.edu/nssr/faculty/?id=4e54-6b79-4e41-3d3d

Universitaet Bielefeld ( email )

Universitätsstraße 25
Bielefeld, NRW
Germany

IIASA ( email )

Schlossplatz 1
Laxenburg/Austria, A-2361
Austria

Alexander Haider

The New School - Department of Economics ( email )

Room 1116
6 East 16th Street
New York, NY 10003
United States

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