Elsevier

Economic Modelling

Volume 56, August 2016, Pages 11-24
Economic Modelling

Monetary shocks, macroprudential shocks and financial stability*

https://doi.org/10.1016/j.econmod.2016.03.003Get rights and content

  • We study the effects of monetary and macroprudential shocks on financial stability.

  • A contractionary monetary shock increases financial fragility.

  • A macroprudential shock does not reduce the debt burden with interest rates fixed.

  • If interest rates can adjust, a macroprudential shock can reduce financial fragility.

  • Policy coordination may help to achieve financial stability.

Abstract

This paper examines the implications of monetary shocks and macroprudential shocks for aggregate financial fragility using a sign restricted VAR model estimated with US data spanning the period 1960Q1–2007Q4. Contractionary monetary shocks are found to exacerbate financial fragility, increasing both the credit to GDP ratio and the ‘financial ratio’, which is the ratio of firms' debts to their internal funds. By contrast, when interest rates are fixed, credit-constraining macroprudential shocks may be able to reduce the credit to GDP ratio in the short run but are not able to reduce the financial ratio. However, when the interest rate is free to accommodate the macroprudential shock, both the credit to GDP ratio and the financial ratio decline, indicating a reduction of financial fragility and suggesting that there may be gains from a coordinated approach to macroeconomic management.

Introduction

Economic history has seen repeated booms and busts in the asset markets which seem neither predictable nor avoidable ex ante. A crude generalisation is that investors undertake progressively more risky positions as rising speculative profits fuel an increasingly bullish outlook until confidence in the sustainability of asset prices eventually fails and the bubble collapses. Subsequently, many commentators are left wondering how so many investors, seasoned and novice alike, were swept up in an ex-post unsustainable clamour to realise speculative gains based largely on market euphoria.

The historical inability of market participants to prevent the growth and subsequent collapse of bubbles has been well documented. This led to a lively debate in the years before the Global Financial Crisis (GFC) as to whether the central bank should — and indeed could — formulate monetary policy to intervene in financial markets (e.g. Cecchetti et al., 2000, Nickell, 2005, Posen, 2006, Roubini, 2006). The dominant view was that a sufficiently aggressive inflation-targeting policy could stabilise both output and inflation in the face of asset price volatility driven either by bubbles or by technology shocks or a combination of the two (Bernanke and Gertler, 2001). Consequently, it was generally believed that monetary policy should only respond to asset prices indirectly via their influence on the optimal inflation forecast. Rather than adjusting interest rates in the hope of preemptively deflating a nascent bubble, the central bank should act to ‘mitigate the fallout’ ex post in the event that the bubble were to burst (Greenspan, 2002). The primary responsibility of the central bank was therefore to maintain price stability which was, in turn, believed to beget financial stability (Schwartz, 1998). Consequently, financial shocks were not a primary concern of central banks and financial regulation mainly operated at the firm level rather than the systemic level.

This consensus has largely dissolved following the GFC and the unprecedented macroeconomic policy response that it instigated. Constrained by the zero lower bound (ZLB), policymakers in many countries employed a mix of countercyclical fiscal policy and unconventional monetary policy. The Federal Reserve was quick to undertake large-scale asset purchases, manipulating its balance sheet as an implement of unconventional monetary policy (Jawadi et al., 2015, Jawadi et al., 2015). Forward guidance also emerged as a prominent tool for guiding interest rate expectations in the anticipation of an eventual normalisation of interest rates.

Interest rate normalisation will not, however, entail a simple return to prior policy arrangements. The policy framework which emerges must adapt to reflect Blanchard et al.’s (2010) observation that the maintenance of price stability is necessary but not sufficient to deliver macroeconomic stability. Indeed, Christiano et al. (2010) show that narrow inflation-targeting may actually exacerbate financial cycles. Their argument is predicated on the observation that asset market booms are not typically associated with high inflation as one would expect under the logic of Bernanke and Gertler (2001). Rather, over the last 200 years, asset booms in the US have been overwhelmingly associated with low inflation. In this environment, narrow inflation-targeting policies may deliver undesirably low interest rates, fueling the boom.

It is well established that interest rate policy is non-neutral with respect to financial stability. For example, the credit channel literature stresses that transaction costs, informational asymmetries between borrowers and lenders and creditors' risk aversion against insolvency may collectively generate financial frictions in imperfect capital markets (Bernanke and Gertler, 1995). An interest rate hike is likely to reduce loan supply and thereby initiate a flight-to-quality which will constrain the borrowing power of smaller firms (Gertler and Gilchrist, 1994, Kashyap and Stein, 1997). In addition, Christiano et al. (1996) show that a monetary contraction will typically reduce both aggregate demand and aggregate cash-inflows, thereby undermining the net worth of the representative borrower and increasing the probability of default, a combined effect that will generate an increased external financing premium (Bernanke et al., 1996). Consequently, both the cost of credit and the conditions governing its supply move in accordance with monetary policy, with the result that the contractionary influence of a rate hike will be concentrated disproportionately among smaller and more informationally opaque firms.

Minsky’s (1982) financial instability hypothesis goes a step further, stressing that the effects of a monetary tightening are not felt only at the idiosyncratic level but also at the systemic level.2 Empirical evidence consistent with this view has been provided by Mallick and Sousa (2013), who document a strongly positive association between monetary tightenings and financial stress. Minsky holds that the link between monetary policy and financial fragility arises because as the central bank changes the interest rate in accordance with its policy objectives, it also changes the cash-commitments of leveraged firms in an imperfectly predictable manner. In an uncertain world, firms faced with long-lived and irreversible investment decisions engage in forward planning based on optimal forecasts of future conditions which, owing to this very uncertainty, must be heavily conditioned on recent historic experience.

A key decision facing firms is the choice of financing structure, with firms undertaking either hedge, speculative or Ponzi financing (Minsky, 1986). Following Sordi and Vercelli, 2006, Vercelli, 2011, these financing structures can be defined with reference to the current and intertemporal financial ratios, kit and kit*: kit=eitzitandkit*=n=0h(1+ρ)neit+n*n=0h(1+ρ)nzit+n*where eit represents cash-outflows, zit denotes cash-inflows, an asterisk signifies an expected value, ρ is the discount rate and the subscripts i = 1, 2,…,N and t = 1, 2,…,T identify firms and time periods, respectively. For any horizon, h, the ith firm is hedge financing if kit < 1 for t = 0 and kit*<1 for 1 ≤ th. It is engaged in speculative financing if kit > 1 for t = 0 and kit*>1 for t ∈ [1,…,s] provided that s < h is a relatively short horizon and kit*<1 for t ∈ [s + 1,…, h]. Finally, it is Ponzi financing if kit > 1 for t = 0 and kit*>1 for 1 ≤ th  1 under the expectation that kit*<<1 in period t = h. Hedge financing is the most prudent strategy when faced with unanticipated shocks, while Ponzi financing involves a considerable risk of insolvency. An unforeseen interest rate hike is likely to raise cash-outflows (by raising the cost of debt-servicing) while simultaneously reducing cash-inflows (by reducing aggregate activity), resulting in a rightward shift through the hedge-speculative-Ponzi spectrum and increasing financial fragility at the aggregate level.

Acknowledging the financial stability implications of monetary policy, several commentators have broken with the prior consensus that asset prices should not enter the interest rate rule. For example, in light of their observation that a narrow inflation targeting policy is likely to deliver undesirably low interest rates during the growth phase of an asset market boom, Christiano et al. (2010) suggest that credit growth should be assigned an independent role in the interest rate rule beyond its influence on the inflation forecast. Similar reasoning underlies a fast-growing literature, both theoretical and empirical, which has sought to augment both monetary and fiscal policy reaction functions with a variety of asset price and wealth indicators (e.g. Agnello et al., 2012, Castro and Sousa, 2012, Mendicino and Punzi, 2014).

In addition to reconsidering the use of existing policy tools, the literature is increasingly emphasising alternative instruments in light of the remarkable broadening of the policy mix brought about by the GFC. With the gradual withdrawal of quantitative easing, macroprudential policies aimed at limiting excessive credit growth and restraining asset price inflation are set to play a key role in mitigating the emergence of financial fragility in the future (Elliott et al., 2013). Macroprudential policies to curtail excessive credit creation and to maintain the creditworthiness of borrowers may be directed at either lenders, borrowers or both (Claessens et al., 2014). On the lenders' side, countercyclical capital requirements of the type proposed in the Basel III Accord can curtail unsafe lending and protect the portfolios of financial institutions from large corrections in the value of collateral assets. Meanwhile, on the borrowers' side, capping the loan-to-value and/or debt-to-income ratios can limit the potential for the emergence of Ponzi financing and strengthen borrowers' incentives to manage funds responsibly by increasing their own stake in debt-funded projects, while also reducing bank losses in the event of default.

Federal Reserve Chair Janet Yellen (2014) has indicated in a recent lecture at the International Monetary Fund that a judicious mix of monetary and macroprudential policies is likely to emerge as the preferred approach to macroeconomic management. The use of macroprudential policies to directly target credit markets provides a valuable complement to monetary policy and gives policymakers greater latitude to achieve multiple goals simultaneously. Based on a New Keynesian model with nominal rigidities and credit frictions, De Paoli and Paustian (2013) show that a combined approach to policymaking has the potential to be welfare-enhancing. However, developing an operational policy framework will be challenging. For instance, De Paoli and Paustian caution that difficult issues of policy coordination may arise due to the interaction of monetary and macroprudential policies, particularly where the monetary and macroprudential policy instruments work in a similar fashion.

In this paper, we therefore study the effects of both monetary shocks and macroprudential shocks on aggregate financial fragility in the US over the period 1960Q1–2007Q4. To this end, we estimate a monetary VAR model augmented to include the prime lending rate, real credit and real internal funds of US non-financial corporate businesses and the real S&P 500 index as well as the key variables usually included in a monetary VAR — the federal funds rate, real output, the general price level and nonborrowed reserves. To identify monetary and macroprudential shocks, we adopt the pure sign restrictions approach of Uhlig (2005). Following a well-established literature, we identify a contractionary monetary shock as one which does not decrease the federal funds rate and which does not increase nonborrowed reserves, output or inflation. Meanwhile, in the absence of a strong precedent, we employ several identification strategies to define a ‘credit-constraining’ macroprudential shock, all of which stress that the shock does not increase credit and stock prices and does not reduce nonborrowed reserves. With the shocks identified, we then infer impulse response functions for the credit to GDP ratio and the corporate financial ratio (the ratio of corporate credit to internal funds, which is a proxy for Sordi and Vercelli’s (2006) current financial ratio) in order to evaluate the financial stability implications of both monetary and macroprudential policies.

Our results indicate that a contractionary monetary shock will raise the credit to GDP ratio and drive a wedge between firms' internal funds and the extent of their debt. Hence, as found by Mallick and Sousa (2013), a monetary tightening will exacerbate financial fragility. By contrast, a credit-constraining macroprudential shock in the absence of interest rate adjustments may be able to reduce the credit to GDP ratio in the short run but is unable to reduce the financial ratio. However, when the interest rate is free to accommodate the macroprudential shock, both the credit to GDP ratio and the financial ratio decline, indicating an unambiguous reduction of financial fragility. The interaction of monetary and macroprudential policy raises the possibility that a combined policy framework may deliver the best outcomes in terms of financial stability, although the attendant issues of policy coordination must be handled with care (De Paoli and Paustian, 2013).

The paper proceeds in 4 sections. Section 2 introduces our empirical methodology, while our estimation results including several robustness tests are presented and discussed in detail in Section 3. Section 4 concludes. Details of the dataset and its construction may be found in the Data Appendix.

Section snippets

VAR specification

Our aim is to build a parsimonious macroeconometric model with which to evaluate the effect of monetary and macroprudential shocks on financial fragility in the aggregate. To this end, we estimate a pth order VAR of the form: Yt=β0+βdt+i=1pβiYti+ϵtwhere Yt is a vector of endogenous variables observed over periods t = 1, 2,…, T, β0 is a vector of intercepts, βd is a vector of deterministic trend terms, the βi’s are matrices of autoregressive parameters and ϵt is a zero-mean error process with

Estimation results

Our sample covers the period 1960Q1–2007Q4, ending before the switch to unconventional monetary policy in the US. Due to the absence of monthly data for several series — notably GDP and the GDP deflator — we use quarterly data to estimate our model. Details of the data sources including series codes and any required transformations are collected in the Data Appendix. Our choice to end the sample in 2007Q4 is made in light of both theoretical and practical concerns. Monetary policy since the GFC

Concluding remarks

This paper studies the effect of monetary and macroprudential shocks on financial fragility in the US over the period 1960Q1–2007Q4. Financial fragility is measured using both the credit to GDP ratio and the corporate financial ratio, which we define as the ratio of corporate credit to internal funds. The former is a measure of credit extension while the latter captures the extent of the debt burden facing firms. Our analysis is based on an extended monetary VAR model where both a

Dr. Matthew Greenwood-Nimmo is a Senior Lecturer in Economics at the University of Melbourne. Matthew completed Undergraduate and Postgraduate degrees in economics at the University of Leeds, graduating with his PhD in 2009. Matthew's research focuses on macroeconomic modelling with particular interests in the analysis of multivariate systems and regime-switching processes.

References (48)

  • SordiS. et al.

    Financial fragility and economic fluctuations

    J. Econ. Behav. Organ.

    (2006)
  • UhligH.

    What are the effects of monetary policy on output? Results from an agnostic identification procedure

    J. Monet. Econ.

    (2005)
  • AkinciO. et al.

    How effective are macroprudential policies? An empirical investigation

  • AlpandaS. et al.

    A policy model to analyze macroprudential regulations and monetary policy

  • The royal road to bankruptcy

    Atlantic Mag.

    (1933)
  • BernankeB. et al.

    Inside the black box: the credit channel of monetary policy transmission

    J. Econ. Perspect.

    (1995)
  • BernankeB. et al.

    Should central banks respond to movements in asset prices?

    Am. Econ. Rev.

    (2001)
  • BernankeB. et al.

    The financial accelerator and the flight to quality

    Rev. Econ. Stat.

    (1996)
  • BlanchardO. et al.

    Rethinking macroeconomic policy

    J. Money, Credit, Bank.

    (2010)
  • BlanchardO. et al.

    The dynamic effects of aggregate demand and supply disturbances

    Am. Econ. Rev.

    (1989)
  • BlanchardO. et al.

    Are all business cycles alike?

  • Brzoza-BrzezinaM. et al.

    Monetary and macroprudential policy with multi-period loans

  • BuschU. et al.

    Loan supply in Germany during the financial crisis

  • CaskeyJ. et al.

    Aggregate demand contractions with nominal debt commitments: is wage flexibility stabilizing?

    Econ. Inq.

    (1987)
  • Cited by (0)

    Dr. Matthew Greenwood-Nimmo is a Senior Lecturer in Economics at the University of Melbourne. Matthew completed Undergraduate and Postgraduate degrees in economics at the University of Leeds, graduating with his PhD in 2009. Matthew's research focuses on macroeconomic modelling with particular interests in the analysis of multivariate systems and regime-switching processes.

    Dr. Artur Tarassow is a post-doctorate fellow at the University of Hamburg. He graduated with his PhD in 2015 at the Universitiy of Hamburg after completing his Postgraduate degree in economics at the University of Leeds. Artur's research focuses on applied macroeconometrics covering monetary policy aspects and firm financing issues.

    *

    We are grateful for the constructive comments of the Editor and four anonymous referees and for the helpful discussion of Ulrich Fritsche, Ingrid Größl, Viet Hoang Nguyen, Yongcheol Shin and Tomasz Woźniak. Our estimation routines employ Ambrogio Cesa-Bianchi's VAR Toolbox for Matlab. Any errors or omissions are our own.

    1

    Tel.: +49 40 42838 8683.

    View full text