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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
Contact details of provider: Postal: Núcleo de Investigação em Políticas Económicas, Escola de Economia e Gestão, Universidade do Minho, P-4710-057 Braga, Portugal
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Web page: http://www3.eeg.uminho.pt/economia/nipe/versao_inglesa/index_uk.htmEmail:


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  1. Lawrence J. Christiano & Martin Eichenbaum & Charles L. Evans, 2005. "Nominal Rigidities and the Dynamic Effects of a Shock to Monetary Policy," Journal of Political Economy, University of Chicago Press, vol. 113(1), pages 1-45, February.
  2. Philip Cagan, 1972. "The Channels of Monetary Effects on Interest Rates," NBER Books, National Bureau of Economic Research, Inc, number caga72-1, November.
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  5. Urban Jermann & Vincenzo Quadrini, 2009. "Macroeconomic Effects of Financial Shocks," NBER Working Papers 15338, National Bureau of Economic Research, Inc.
  6. Troy Davig & Craig 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.
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  8. Vítor Castro, 2008. "The duration of economic expansions and recessions: More than duration dependence," NIPE Working Papers 18/2008, NIPE - Universidade do Minho.
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  10. Ricardo M. Sousa, 2006. "Consumption, (Dis)Aggregate Wealth and Asset Returns," Computing in Economics and Finance 2006 212, Society for Computational Economics.
  11. 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.
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  13. James Peery Cover, 2011. "Risk and Macroeconomic Activity," Southern Economic Journal, Southern Economic Association, vol. 78(1), pages 149-166, July.
  14. Vincenzo Quadrini, 2011. "Financial frictions in macroeconomic fluctations," Economic Quarterly, Federal Reserve Bank of Richmond, issue 3Q, pages 209-254.
  15. 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.
  16. Cardarelli, Roberto & Elekdag, Selim & Lall, Subir, 2011. "Financial stress and economic contractions," Journal of Financial Stability, Elsevier, vol. 7(2), pages 78-97, June.
  17. 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.
  18. Urban Jermann & Vincenzo Quadrini, 2012. "Erratum: Macroeconomic Effects of Financial Shocks," American Economic Review, American Economic Association, vol. 102(2), pages 1186-1186, April.
  19. 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.
  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. 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.
  22. 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.
  23. 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.
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