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Board of Governors of the Federal Reserve System (US)
Finance and Economics Discussion Series
Distress in the financial sector and economic activity
Mark A. Carlson
Thomas B. King
Kurt F. Lewis
Abstract

This paper explores the relationship between the health of the financial sector and the rest of the economy. We develop an indicator of financial sector health using a distance-to-default measure based on a Merton-style option pricing model. Our measure spans over three decades and appears to capture periods when financial sector institutions were strong and when they were weak. We then use vector autoregressions to assess whether our indicator of financial-sector health affects the real economy, in particular non-residential investment. The results indicate that our measure has a considerable impact. Moreover, we find that this financial channel amplifies changes in investment resulting from shocks to non-financial firm profitability.


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Mark A. Carlson & Thomas B. King & Kurt F. Lewis, Distress in the financial sector and economic activity, Board of Governors of the Federal Reserve System (US), Finance and Economics Discussion Series 2009-01, 2009.
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Keywords: Fiscal policy ; Government spending policy
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