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The Role of Financial Depth on The Asymmetric Impact of Monetary Policy

Listed author(s):
  • Mustafa Caglayan
  • Ozge Kandemir Kocaaslan
  • Kostas Mouratidis

There is a growing literature on the importance of financial markets arguing that credit market imperfections act as a propagator of shocks and play a significant role in magnifying output fluctuations. However, we do not see any study that empirically studies the examines the role of financial markets on the effectiveness of monetary policy. This paper investigates the role of financial markets in evaluating the asymmetric impact of monetary policy on real output over the business cycle.To examine the role of financial markets in determining the impact of monetary policy on real output, we implement an instrumental variables Markov regime switching framework. A first draft is prepared and is attached to this conference submission.Results can be summarized as follows: i)Monetary policy has a regime dependent impact on output growth: a restrictive monetary policy has a negative and significant impact on output growth during recessions, yet this effect is not significant during expansions; ii) Financial depth significantly mitigates the impact of monetary policy in recessions. More concretely, we find that in recessions the total impact of monetary policy on output growth becomes much milder and even diminishes with the deepening of the financial markets. This finding makes sense firms mostly suffer from financial frictions during periods of recessions; however, deeper financial markets could help firms to raise funds even in bad times.

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Paper provided by EcoMod in its series EcoMod2015 with number 8285.

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Date of creation: 01 Jul 2015
Handle: RePEc:ekd:008007:8285
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