Monetary Policy, Financial Shocks and Economic Activity

Abstract

This paper contributes to a deeper understanding of macroeconomic outcomes to financial market disturbances and the central bank’s role in financial stability, by using Bayesian VAR (BVAR) models. We document that a shock that increases credit to non-financial sector leads to a persistent decline in economic activity. In addition, we examine whether the behavior of financial variables is useful in signaling the 2008 recession. The answer is positive as our medium-scale BVAR generates early warning signals pointing to a sustained slowdown in growth. Finally, we suggest that the expansion phase of the business cycle can be subdivided into an early and a late expansion. Based on this distinction, we show that if the Fed had raised the policy rate when the economy moved from the early to late expansion, it could have mitigated the severity of the last recession.

Keywords: financial shocks, credit, spreads, VAR, financial crisis, monetary policy

JEL Classification: E50, E52, E58