Financial Uncertainty and the Effectiveness of Monetary Policy

Abstract

This paper argues that the impact of monetary policy shocks can interact with the financial environment, in particular with financial uncertainty, making monetary policy's effectiveness state dependent. To that end, we implement a smooth transition VAR model to examine monetary policy shocks, in which the transition between different states depends on the financial uncertainty index of Ludvigson et al. (2015). This uncertainty index extracts the variance of the unforecastable components from a large financial dataset and has advantages over other uncertainty measures. The work identifies that monetary shocks have stronger, but less persistent, effects during periods of elevated financial uncertainty than during tranquil times. These differences in effects among the uncertainty-dependent states suggest that nonlinearities in the credit channel are stronger in the short run, whereas in the long run nonlinearities in the interest rate channel dominate.