The link between financial stress index and economic activity: prominent Granger causalities across frequencies in Luxembourg

Abstract

PurposeIn spite of the certain risk imposed by financial stress on the real economy, the relationship between financial stress and economic activity is complicated and underresearched, meaning that important gaps still remain in the authors’ understanding of this critical relationship. Therefore, the current study aims to answer the significant question regarding whether a stressful financial sector has predictive power on the real sector and vice versa. Hence, the study examines the causal interrelationship between financial stress index (FSI) and economic activity in Luxembourg as a sample country.Design/methodology/approachIn this study, accompanying the time domain Granger causality framework of Hacker and Hatemi-J (2012), the authors utilize the spectral causality technique of Breitung and Candelon (2006), which is based on the study of Geweke (1982) and Hosoya (1991). This method enables the researcher to measure the degree of a particular variation in time series. Moreover, it allows considering the nonlinearities and causality cycles. The authors further apply the recent method of Farné and Montanari (2018) that is a bootstrap framework on Granger-causality spectra, which allows for disambiguation in causalities.FindingsThe time-domain approach finds evidence of bidirectional causation between the variables. However, the spectral causality results indicate the causal linkages between the series are only valid under the medium-run frequency. This study’s findings emphasize covering the frequency causality to deliver a more comprehensive picture of the interrelationship between the variables.Originality/valueThere are many studies in this area that examine the nexus between financial stress and economic activity. However, the authors believe this paper is the first study in the context of Luxemburg. The authors focus on this country since its financial sector is designated as the most important pillar for the economy. Thus, a careful and reliable examination of the relationship between the financial sector and economic activity is likely to be of considerable interest to policymakers and researchers in this field.

The dance of dependence: a macro-perspective on financial instability and its complex influence on the Euro-American green markets

“…Following the same all-encompassing perspective, we use two comprehensive measures of financial instability, the Composite Systemic Stress Indicator (CISS) in the EU (CISS_EU) and the U.S. (CISS_US) (Holl o et al, 2012). Indeed, rather than being limited to financial crises, market volatility, and large deviations in asset prices, financial system instability includes broader phenomena in the equity and bond markets, the banking sector, as well as the foreign exchange market (Bahramian et al, 2022;Berisha et al, 2022;Gaies et al, 2022). Therefore, when measuring financial instability, it is crucial to capture the efficiency with which savings are allocated and the availability of liquidity, as well as the ability of the system to prevent, absorb, and respond to financial turbulence before it compromises its functionality.…”

“…When financial instability peaks in developed markets, particularly in the United States (U.S.) and the European Union (EU), it has major repercussions for the real global economy, as was clearly demonstrated by the 2008 global financial crisis (GFC). Increasing market contagion around the world is putting the global financial system at risk, making its stability a top priority for policymakers to avoid serious economic and social threats (He et al, 2021;Berisha et al, 2022;Bahramian et al, 2022). To mitigate the impact of the GFC by improving employment rates and increasing spending, central banks around the world, especially in the U.S. and EU, cut interest rates, which boosted liquidity in the capital markets.…”

“…, 2012). Indeed, rather than being limited to financial crises, market volatility, and large deviations in asset prices, financial system instability includes broader phenomena in the equity and bond markets, the banking sector, as well as the foreign exchange market (Bahramian et al. , 2022; Berisha et al.…”