Financial stress and economic dynamics: The transmission of crises

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.