What are the effects of financial stress on economic activity and government debt? An empirical examination in an emerging economy

Abstract

Using a Bayesian Vector Autoregressive Model (BVAR) analysis, this paper explores the link between financial stress, economic activity, and government debt in Turkiye from January 1992 to December 2020. First, using the equally variance weighting approach, we calculate a financial stress index (FSI). Second, using the FSI, we estimate the BVAR model for the Turkish economy. The results of the BVAR model reveal that a positive financial stress shock is harmful for economic activity because it raises government debt. The findings also show that a positive government debt shock increases financial stress. Surprisingly, both government debt and financial stress diminish in response to a positive shock in economic activity. The conclusions of the study have substantial implications for future fiscal policy approaches.