July 2016

Financial Vulnerabilities, Macroeconomic Dynamics, and Monetary Policy

David Aikman, Andreas Lehnert, Nellie Liang, and Michele Modugno


We define a measure to be a financial vulnerability if, in a VAR framework that allows for nonlinearities, an impulse to the measure leads to an economic contraction. We evaluate alternative macrofinancial imbalances as vulnerabilities: nonfinancial sector credit, risk appetite of financial market participants, and the leverage and short-term funding of financial firms. We find that nonfinancial credit is a vulnerability: impulses to the credit-to-GDP gap when it is high leads to a recession. Risk appetite leads to an economic expansion in the near-term, but also higher credit and a recession in later years, suggesting an intertemporal tradeoff. Monetary policy is generally ineffective at slowing the economy once the credit-to-GDP gap is high, suggesting important benefits from avoiding excessive credit growth. Financial sector leverage and short-term funding do not lead directly to contractions and thus are not vulnerabilities by our definition.

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Keywords: Financial stability and risk, credit, monetary policy

DOI: http://dx.doi.org/10.17016/FEDS.2016.055

PDF: Full Paper

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Last Update: June 19, 2020