Financial Stress and Economic Dynamics: The Transmission of Crises

By Robert J. Tetlow, K. Hubrich. Social Science Research Network, 2015

303 citations recorded by the source corpus.

The recent financial crisis and the associated decline in economic activity have raised some important questions about economic activity and its links to the financial sector. This paper introduces an index of financial stress - an index that was used in real time by the staff of the Federal Reserve Board to monitor the crisis - and shows how stress interacts with real activity, inflation and monetary policy. We define what we call a stress event - a period affected by stress in both shock variances and model coefficients - and describe how financial stress affects macroeconomic dynamics. We also examine what constitutes a useful and credible measure of stress and the role of monetary policy. We address these questions using a richly parameterized Markov-switching VAR model, estimated using Bayesian methods. Our results show that allowing for time variation is important: the constant-parameter, constant-shock-variance model is a poor characterization of the data. We find that periods of high stress coefficients in general, and stress events in particular, line up well with financial events in recent U.S. history. We find that a shift to a stress event is highly detrimental to the outlook for the real economy, and that conventional monetary policy is relatively weak during such periods. Finally, we argue that our findings have implications for DSGE modeling of financial events insofar as researchers wish to capture phenomena more consequential than garden-variety business cycle fluctuations, pointing away from linearized DSGE models toward either MS-DSGE models or fully nonlinear models solved with global methods.

Subfields: Economics and Econometrics, Finance

View Paper: https://www.semanticscholar.org/paper/ea5c1c1c35444e8c8bd72dc0905fe7f07866b9ed

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Citations in the corpus

The Role of Oil Price Shocks in Causing U.S. Recessions (2014, background): “We focus on the NFCI because of all indicators of U.S. financial stress this index is available for the longest time span, but Table 2 also includes results for the Federal Reserve Board Staff Financial Stress Index, which is available since 1988 (see Hubrich and Tetlow 2012).”
Generalized Forecast Error Variance Decomposition for Linear and Nonlinear Multivariate Models (2014, unknown): “…worth pointing out that a closely related literature provides evidence of various credit and corporate bond spreads having predictive power for real output (see, e.g., Gilchrist, Yankov and Zakraj²ek (2009), Gilchrist and Zakraj²ek (2012) and Hubrich and Tetlow (2015), and the references therein).”
CISS - A Composite Indicator of Systemic Stress in the Financial System (2012, unknown): “…be more thoroughly and robustly investigated by including the CISS in regime-switching VAR models along with a broader set of macroeconomic aggregates like in Hartmann et al. (2012) for the euro area and in Hubrich and Tetlow (2010) for the United States based on a different financial stress index.”
THRESHOLDS AND SMOOTH TRANSITIONS IN VECTOR AUTOREGRESSIVE MODELS (2013, background): “Recent economic applications include Sims and Zha (2006) and Hubrich and Tetlow (2012).”
SRISK: A Conditional Capital Shortfall Index for Systemic Risk Measurement (2012, unknown): “In fact, Hubrich and Tetlow (2015), for example, provide empirical evidence that the linkages between financial frictions and the macroeconomy become relevant when the financial system is distressed and not operating normally.”