Financial or non-financial shocks: rivals that play together

Abstract

AbstractThis paper estimates a model using Bayesian methods and data from the USA (1990Q1–2019Q2) to explore how the financial sector contributes to business cycles through banks’ asset channel and the quality of capital adequacy constraint. The paper shows that the contribution of financial and non-financial shocks varied before, during, and after the 2008 financial crisis; housing demand and asset price shocks are the main contributors, and the credit shocks are the most persistent. In addition, the paper presents the application of macroprudential tools, along with their impact on the economy in general, and on welfare in particular. The findings illustrate that the tools which control household borrowing ability, such as loan-to-value or debt-to-income ratios, do not impact welfare significantly. However, the impact of policies on the leveraged sector is substantial. The paper proposes macroprudential policies that allow policy-makers to stabilize the economy without changing welfare. Such policies, however, should be timely, targeted, and temporary; otherwise, they may cause disruptions.