Melting down: Systemic financial instability and the macroeconomy

We integrate systemic financial instability in an empirical macroeconomic model for the euro area. We find that at times of widespread financial instability the macroeconomy functions fundamentally differently from tranquil times. We employ a richly specified MarkovSwitching Vector Autoregression model to capture the dynamic relationships between a set of core macroeconomic variables and a novel indicator of systemic financial stress. Both the parameters that capture the transmission of shocks through the economy and the variances of the shocks change at times of high stress in the financial system. In particular, the negative output effects of sizeable increases in financial stress are much larger after such a regime ∗We would like to thank participants at the Offi ce of Financial Research/Financial Stability Oversight Council conference “The Macroprudential Toolkit”, the Deutsche Bundesbank/Institute for Monetary and Financial Stability/SUERF conference “The ESRB at 1”, a meeting of the ESCB Macroprudential Research (MaRs) network, the 2012 European Economic Association Meetings and a Bank of Canada seminar for comments. Vesela Ivanova and Cristina Manea provided excellent research assistance. The views expressed are only the authors’and should not be associated with offi cial views of the European Central Bank, the Eurosystem or the Federal Reserve Board. †European Central Bank, Kaiserstr. 29, D-60311 Frankfurt am Main, Germany, e-mail [email protected], Erasmus University Rotterdam and Centre for Economic Policy Research (CEPR), London, United Kingdom ‡European Central Bank, Kaiserstr. 29, D-60311 Frankfurt am Main, Germany, tel. +49-69-1344-6358, e-mail [email protected] §European Central Bank, Kaiserstr. 29, D-60311 Frankfurt am Main, Germany, tel. +49-69-1344-7065, e-mail [email protected] ¶Federal Reserve Board, Washington, D.C., USA, e-mail [email protected]. 1 change than during tranquil times. Macroprudential and monetary policy makers are well advised to take these non-linearities into account. JEL Classification: E44, C11, C32