The impact of the financial cycle on the economic cycle and the regulatory role of monetary policy: evidence from China

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PurposeFirst, we explored the dynamic relationship between the economic and financial cycles under a unified endogenous framework. There is less literature on the relationship between the financial cycle and the economic cycle endogenously under a unified framework. Our research helps to fill the gap in this area. Second, there is no conclusive evidence on whether the monetary policy framework should take the financial cycle into account. Our findings provide a clear answer and a useful reference for the practice of monetary policy in other countries.Design/methodology/approachWe incorporate the financial cycle equation based on the traditional new Keynesian model to construct a new Keynesian four-equation model that includes financial factors and further explores the dynamic relationship between the economic cycle and the financial cycle under a unified endogenous framework. We choose the three-stage least squares (3SLS) method for the estimation of the model. Then we utilize a time-varying parameter vector autoregression (TVP-SV-VAR) model incorporating stochastic volatility to explore the mechanism of the dynamic association between the financial cycle and monetary policy in China.FindingsFirst, we explored the relationship between the economic cycle and the financial cycle. The results show that the financial cycle has a significant positive impact on the economic cycle, but the economic cycle has a limited effect on the financial cycle. Then, we examine the linkage mechanism between China’s economic cycle, financial cycle and monetary policy. The results show that the response of China’s monetary policy to economic cycle shocks and financial cycle shocks is more significant. Moreover, monetary policy is giving higher and higher weight to the financial cycle.Originality/valueFirst, we constructed a new Keynesian four-equation model incorporating financial factors to explore the dynamic relationship between the economic and financial cycles under a unified endogenous framework. There is less literature on the relationship between the financial cycle and the economic cycle endogenously under a unified framework. Our research helps to fill the gap in this area. Second, there is no conclusive evidence on whether the monetary policy framework should take the financial cycle into account. Our findings provide a clear answer and a useful reference for the practice of monetary policy in other countries.