Financial Stress, Regime Switching and Macrodynamics

Abstract

Monetary responses to financial stress have recently become an important issue in macroeconomic and policy discussions in the USA as well as in the EU. In this paper, the authors study two regimes of monetary responses. While the fundamentals of an economy are assumed to have a long-run equilibrium, the adjustment process towards the equilibrium can be different in different regimes. During a period of deteriorated economic conditions, rate cuts are the most often applied policy responses. Therefore, rate cuts can be used as a natural regime identifier. We observe that the financial stress shocks have a large and persistent negative impact on the real side of the economy, and their impact is stronger in the non-rate-cut regime than in the rate-cut regime. A macro-foundation of such a Finance-Macro model type is given in Mittnik and Semmler (J Econ Behav Organ 83:502–522, 2013) and Chen and Semmler (J Econ Dyn Control 91:318–348, 2018). The agents can, in a finite horizon context, borrow and accumulate assets where however the above two scenarios may occur. The model is solved through nonlinear model predictive control (NMPC). Empirically we use a multi-regime cointegrated VAR (MRCIVAR) to study the impact of financial stress shocks and monetary policy on the macroeconomy in different countries.