The empirical evaluation of monetary policy shock in dynamic stochastic general equilibrium model with financial frictions

Irena Palić

doi:10.1177/1847979018758740

Abstract

Large body of empirical literature points to the tight integration of financial and credit markets with real economic activity as well as the need for inclusion of financial frictions into macroeconomic modelling. After the recent mortgage loan crisis which spilled over into the global financial crisis, the assessment of relationship of monetary policy and house prices gained in importance. The aim of this article is to test the compliance of monetary policy shock in calibrated dynamic stochastic general equilibrium (DSGE) model which includes financial frictions with the empirical impact of monetary policy shock in Croatia estimated using vector autoregression (VAR) model. After the DSGE model is calibrated, the VAR model is estimated for Croatia. The comparative analysis of impulse response functions of DSGE and VAR model is conducted. In both models, monetary policy shock has positive initial impact on interest rate and negative initial impact on house prices and output gap. Results indicate that empir...

Highlights

The recent global financial crisis that originated in summer 2007 from United States as subprime mortgage market crisis has pointed to the fact that change in credit supply can have key role in macroeconomic fluctuations
The aim of this article is to assess whether the impact of monetary policy shock in Croatia, which is approximated by money market interest rate shock, fits the impact of interest rate shock in calibrated dynamic stochastic general equilibrium (DSGE) model with financial frictions for Croatian economy
Impulse response functions of calibrated DSGE model are compared to the impulse response functions of the estimated vector autoregression (VAR) of the Croatian economy, which is a common approach to the evaluation of the DSGE models

Summary

Introduction

The recent global financial crisis that originated in summer 2007 from United States as subprime mortgage market crisis has pointed to the fact that change in credit supply can have key role in macroeconomic fluctuations. Banks have overestimated their assets, and together with the fragility of the financial system, the mortgage loan crisis emerged and spilled over into the global financial crisis. While in the calm periods the financial sector can alleviate financial friction, in times of crisis the fragility of the financial sector leads to instability.[2]. The research of Christiano et al.[4]

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Conclusion