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The real effects of financial stress in the Euro zone

Using two identification strategies based on a Bayesian Structural VAR and a Sign-Restriction VAR, we examine the real effects of financial stress in the Eurozone. In particular, we assess the macroeconomic impact of: (i) a monetary policy shock; and (ii ) a financial stress shock. We find that a monetary policy contraction strongly deteriorates financial stress conditions. In addition, unexpected variation in the Financial Stress Index (FSI) plays an important role in explaining output fluctuations, and also demands an aggressive response by the monetary authority to stabilise output indicating a preference shift from targeting inflation as it is currently happening in major economies. Therefore, our paper reveals the importance of adopting a vigilant posture towards financial stress conditions, as well as the urgency of macro-prudential risk management.

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File URL: http://www3.eeg.uminho.pt/economia/nipe/docs/2011/NIPE_WP_12_2011.pdf
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Paper provided by NIPE - Universidade do Minho in its series NIPE Working Papers with number 12/2011.

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Date of creation: 2011
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Handle: RePEc:nip:nipewp:12/2011
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Núcleo de Investigação em Políticas Económicas, Escola de Economia e Gestão, Universidade do Minho, P-4710-057 Braga, Portugal

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  1. Lawrence J. Christiano & Martin Eichenbaum & Charles L. Evans, 2001. "Nominal rigidities and the dynamic effects of a shock to monetary policy," Working Paper 0107, Federal Reserve Bank of Cleveland.
  2. Urban Jermann & Vincenzo Quadrini, 2012. "Macroeconomic Effects of Financial Shocks," American Economic Review, American Economic Association, vol. 102(1), pages 238-71, February.
  3. Martin, Christopher & Costas Milas, 2002. "Modelling Monetary Policy: Inflation Targeting in Practice," Royal Economic Society Annual Conference 2002 137, Royal Economic Society.
  4. Rafiq, M.S. & Mallick, S.K., 2008. "The effect of monetary policy on output in EMU3: A sign restriction approach," Journal of Macroeconomics, Elsevier, vol. 30(4), pages 1756-1791, December.
  5. Vítor, Castro, 2011. "Can central banks' monetary policy be described by a linear (augmented) Taylor rule or by a nonlinear rule?," Journal of Financial Stability, Elsevier, vol. 7(4), pages 228-246, December.
  6. Nicholas Bloom, 2007. "The Impact of Uncertainty Shocks," NBER Working Papers 13385, National Bureau of Economic Research, Inc.
  7. Philip Cagan, 1972. "Introduction to "The Channels of Monetary Effects on Interest Rates"," NBER Chapters, in: The Channels of Monetary Effects on Interest Rates, pages 1-8 National Bureau of Economic Research, Inc.
  8. Craig S. Hakkio & William R. Keeton, 2009. "Financial stress: what is it, how can it be measured, and why does it matter?," Economic Review, Federal Reserve Bank of Kansas City, issue Q II, pages 5-50.
  9. Sousa, Ricardo M., 2010. "Housing wealth, financial wealth, money demand and policy rule: Evidence from the euro area," The North American Journal of Economics and Finance, Elsevier, vol. 21(1), pages 88-105, March.
  10. James Peery Cover, 2011. "Risk and Macroeconomic Activity," Southern Economic Journal, Southern Economic Association, vol. 78(1), pages 149-166, July.
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  12. Uhlig, Harald, 2005. "What are the effects of monetary policy on output? Results from an agnostic identification procedure," Journal of Monetary Economics, Elsevier, vol. 52(2), pages 381-419, March.
  13. Sousa, Ricardo M., 2010. "Consumption, (dis)aggregate wealth, and asset returns," Journal of Empirical Finance, Elsevier, vol. 17(4), pages 606-622, September.
  14. repec:fip:fedreq:y:2011:i:3q:p:209-254:n:vol.97no.3 is not listed on IDEAS
  15. Vítor Castro, 2008. "The duration of economic expansions and recessions: More than duration dependence," NIPE Working Papers 18/2008, NIPE - Universidade do Minho.
  16. Urban Jermann & Vincenzo Quadrini, 2012. "Erratum: Macroeconomic Effects of Financial Shocks," American Economic Review, American Economic Association, vol. 102(2), pages 1186-1186, April.
  17. Troy A. Davig & Craig S. Hakkio, 2010. "What is the effect of financial stress on economic activity," Economic Review, Federal Reserve Bank of Kansas City, issue Q II, pages 35-62.
  18. Marco A. Espinosa-Vega, 1998. "How powerful is monetary policy in the long run?," Economic Review, Federal Reserve Bank of Atlanta, issue Q 3, pages 12-31.
  19. Aksoy, Yunus & León-Ledesma, Miguel A., 2005. "Interest rates and output in the long-run," Working Paper Series 0434, European Central Bank.
  20. Sushanta Mallick & Helena Marques, 2008. "Exchange Rate Transmission into Industry-Level Export Prices: A Tale of Two Policy Regimes in India," IMF Staff Papers, Palgrave Macmillan, vol. 55(1), pages 83-108, April.
  21. Cardarelli, Roberto & Elekdag, Selim & Lall, Subir, 2011. "Financial stress and economic contractions," Journal of Financial Stability, Elsevier, vol. 7(2), pages 78-97, June.
  22. Granville, Brigitte & Mallick, Sushanta, 2009. "Monetary and financial stability in the euro area: Pro-cyclicality versus trade-off," Journal of International Financial Markets, Institutions and Money, Elsevier, vol. 19(4), pages 662-674, October.
  23. Philip Cagan, 1972. "The Channels of Monetary Effects on Interest Rates," NBER Books, National Bureau of Economic Research, Inc, number caga72-1, September.
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