Dynamic responses of real output to financial spreads

Abstract

In this paper, we find that a positive term spread shock permanently increases real output in that the long-term trend rises. The mechanism is likely through the strong association between term spread shocks and total factor productivity news shocks. A positive credit spread shock could reflect heightening default risk and tightening credit supply, and both factors can lead to fewer new investment projects and damage the long-run economic capacity. We find that for credit spread shocks representing tightening credit supply conditions, the permanent effect is significant in a counterfactual case in which the public forecasts future short rates without considering credit spread. This finding suggests that the central bank's commitment to provide liquidity is important to prevent permanent output loss due to a shortage of credit.