Financial Vulnerabilities, Macroeconomic Dynamics, and Monetary Policy

54 Pages Posted: 15 Jul 2016 Last revised: 14 Jul 2021

See all articles by David Aikman

David Aikman

Bank of England - Monetary Assessment and Strategy Division

Andreas Lehnert

Board of Governors of the Federal Reserve System

Nellie Liang

Brookings Institution

Michele Modugno

Board of Governors of the Federal Reserve System

Date Written: July, 2016

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.

JEL Classification: E58, E65, G28

Suggested Citation

Aikman, David and Lehnert, Andreas and Liang, Nellie and Modugno, Michele, Financial Vulnerabilities, Macroeconomic Dynamics, and Monetary Policy (July, 2016). FEDS Working Paper No. 2016-55, Available at SSRN: https://ssrn.com/abstract=2810052 or http://dx.doi.org/10.17016/FEDS.2016.055

David Aikman (Contact Author)

Bank of England - Monetary Assessment and Strategy Division ( email )

Threadneedle Street
London EC2R 8AH
United Kingdom

Andreas Lehnert

Board of Governors of the Federal Reserve System ( email )

20th Street and Constitution Avenue NW
Washington, DC 20551
United States
202-452-3325 (Phone)
202-263-4852 (Fax)

Nellie Liang

Brookings Institution

1775 Massachusetts Ave, NW
Washington, DC 20036
United States

Michele Modugno

Board of Governors of the Federal Reserve System ( email )

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

Do you have a job opening that you would like to promote on SSRN?

Paper statistics

Downloads
217
Abstract Views
1,486
Rank
289,858
PlumX Metrics