Time Varying Monetary Policy Rules and Financial Stress

Abstract

We examine whether and how main central banks responded to episodes of financial stress over the last three decades. For this reason, we employ a novel methodology for monetary policy rules estimation, which allows for time-varying coefficients as well as corrects for endogeneity. This flexible framework applied to the U.S., U.K., Australia, Canada and Sweden together with a new financial stress dataset developed by the International Monetary Fund allows not only testing whether the central banks responded to financial stress but also detecting the periods and type of stress that were for monetary authorities the most worrying. Our findings suggest that central banks loosen monetary policy in the face of high financial stress, but the size of such response stress varies substantially over time as well as across countries. As regards the specific components of financial stress, most central banks seemed to respond to stock market stress and bank stress, while exchange rate stress is found to drive the reaction of central banks only in more open economies. JEL Classification: E43, E52, E58.