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Financial Stress, Monetary Policy, and Economic Activity

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  • Fuchun Li
  • Pierre St-Amant

Abstract

This paper examines empirically the impact of financial stress on the transmission of monetary policy shocks in Canada. The model used is a threshold vector autoregression in which a regime change occurs if financial stress conditions cross a critical threshold. Using the financial stress index developed by Illing and Liu (2006) as a measure of the Canadian financial stress conditions, the authors examine questions such as: Do contractionary and expansionary monetary policy shocks have symmetric effects? Do financial stress conditions play a role as a nonlinear propagator of monetary policy shocks? Does monetary policy have the same effect on the real economy in the low financial stress regime and in the high financial stress regime? Suppose that the economy is currently in a given financial stress regime, do monetary policy shocks have a substantial effect on the transition probability of moving from the given regime to the other? The empirical findings reveal that (i) contractionary monetary shocks typically have a larger effect on output than expansionary monetary shocks; (ii) the effects of large and small shocks are approximately proportional; (iii) expansionary monetary shocks have larger effects on output in the high financial stress regime than in the low financial stress regime; (iv) large expansionary monetary shocks increase the likelihood of moving to, or remaining in, the low financial stress regime; (v) typically, high financial stress regime has been characterized by weaker output growth, higher inflation, and higher interest rates.

Suggested Citation

  • Fuchun Li & Pierre St-Amant, 2010. "Financial Stress, Monetary Policy, and Economic Activity," Staff Working Papers 10-12, Bank of Canada.
  • Handle: RePEc:bca:bocawp:10-12
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    References listed on IDEAS

    as
    1. Rhee, Wooheon & Rich, Robert W., 1995. "Inflation and the asymmetric effects of money on output fluctuations," Journal of Macroeconomics, Elsevier, vol. 17(4), pages 683-702.
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    3. Weise, Charles L, 1999. "The Asymmetric Effects of Monetary Policy: A Nonlinear Vector Autoregression Approach," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 31(1), pages 85-108, February.
    4. Thoma, Mark A., 1994. "Subsample instability and asymmetries in money-income causality," Journal of Econometrics, Elsevier, vol. 64(1-2), pages 279-306.
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    More about this item

    Keywords

    Financial stability; Monetary policy and uncertainty;

    JEL classification:

    • G01 - Financial Economics - - General - - - Financial Crises
    • E50 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - General
    • C01 - Mathematical and Quantitative Methods - - General - - - Econometrics

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