Financial or Non-financial Shocks: Rivals That Play Together

Abstract

This paper estimates a DSGE model to explore how the economy is affected by financial and non-financial shocks. Bayesian methods and data from the US corroborate the results. This paper first illustrates how the financial sector is not only a transfer channel for exogenous shocks to the real economy, but also a contributor to business cycles through banks’ asset reallocation channel and the quality of capital adequacy constraint. The paper then shows that the contribution of financial and non-financial shocks has varied before, during and after the recent 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.