Working Paper

Financial Vulnerabilities, Macroeconomic Dynamics, and Monetary Policy

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.

Keywords: Financial stability and risk; Monetary policy; Credit;

JEL Classification: E58; E65; G28;

Access Documents


Bibliographic Information

Provider: Board of Governors of the Federal Reserve System (U.S.)

Part of Series: Finance and Economics Discussion Series

Publication Date: 2016-07-07

Number: 2016-055

Pages: 53 pages