Financial Cycle, Business Cycle and Monetary Policy: Evidence from Four Major Economies

Abstract

Economists used to think that financial factors are not important in the business cycle, but the 2008 global financial crisis has made it apparent that financial cycle plays a much larger role in macroeconomic dynamics than anticipated. Against this background, economists endeavor to introduce financial factors into macroeconomic models. In this paper, we incorporate financial cycle into a four‐equation model to study the linkages and interactions between financial cycle, business cycle and monetary policy. The results suggest that financial cycle plays a significant role in the business cycle, and that financial cycle shock has become a main driving force for macroeconomic fluctuations, especially during times of financial instability. In addition, by comparing the performance of the finance‐augmented Taylor rule with that of the conventional Taylor rule, we find that both the financial system and the real economy will be better stabilized under the finance‐augmented Taylor rule. This result adds new evidence to the argument that monetary policy has an important role in safeguarding the financial system and that financial stability should be adopted as a target for monetary policy. Copyright © 2016 John Wiley & Sons, Ltd.

Nonfinancial sector debt and the U.S. Great Moderation: Evidence from flow‐of‐funds data

“…Jermann and Quadrini (2006) similarly show in a general equilibrium model how innovations in financial markets can generate a lower volatility of output, together with a higher volatility in the financial structure of firms. A broader strand of literature connects credit conditions to the business cycle and the economy's volatility (e.g., Bliss & Kaufmann, 2003;Ma & Zhang, 2016;Mendicino, 2007), making the general point that financial development tends to stabilize growth (Easterly, Islam, & Stiglitz, 2000). A broader strand of literature connects credit conditions to the business cycle and the economy's volatility (e.g., Bliss & Kaufmann, 2003;Ma & Zhang, 2016;Mendicino, 2007), making the general point that financial development tends to stabilize growth (Easterly, Islam, & Stiglitz, 2000).…”

“…"Credit View" literature (Bernanke, 1993;Bernanke & Blinder, 1988;Bernanke & Gertler, 1995) and accelerator models (Campbell, 2005;Kiyotaki & Moore, 1997) theorize how the credit system may either amplify or dampen exogenous shocks. A broader strand of literature connects credit conditions to the business cycle and the economy's volatility (e.g., Bliss & Kaufmann, 2003;Ma & Zhang, 2016;Mendicino, 2007), making the general point that financial development tends to stabilize growth (Easterly, Islam, & Stiglitz, 2000). Specific to the Great Moderation, Davis and Kahn (2008) find that an important part of the decline in macro volatility is explained by changes in aggregate volatility in the durable goods sector, but without a decline in the uncertainty of incomes.…”

Short and medium term financial-real cycles: An empirical assessment

“…Kiyotaki and Moore 1997;Bernanke et al 1999;Ryoo 2010Ryoo , 2013Ryoo , 2016, there appear to be no empirical investigations attempting to disentangle the causal mechanisms driving financial-real interactions. A recent exception is the study by Ma and Zhang (2016), which jointly estimate an output gap equation, a Phillips curve, a monetary policy function, and an equation with a composite financial cycle index for the USA, UK, Japan, and China. They find that shocks to the financial cycle index explain between 35% to 44% of the variance in the output gap and interpret this as evidence for an important role of the financial cycle in business cycle dynamics.…”

Identifying a robust policy rule for the Fed's response to financial stress

“…As central banks are generally also responsible for financial stability (Agénor & Pereira da Silva, ), one possible extension to the standard Taylor rule is to allow policymakers to also respond to financial conditions. From a theoretical perspective, Curdia and Woodford () show that a Taylor rule that includes a direct response to the credit spread can help reduce the distortions caused by a financial disturbance, whereas Ma and Zhang () determine that a Taylor rule that accounts for financial factors is better able to both safeguard the financial system and stabilize the business cycle. Moreover, if policymakers are reacting to economic and financial conditions asymmetrically, then a linear Taylor rule becomes a weak approximation for the true policy reaction function and can lead to inaccurate inference.…”