Financial Stress, Monetary Policy, and Economic Activity

The recent global crisis was characterized by a remarkable intensity in the negative feedback process between financial sector developments and the real economy. Exceptional measures were required to break this process, and the crisis stimulated interest in the relationship between financial sector developments, the real economy, and monetary policy. The authors examine this relationship by reviewing the relevant literature and then estimating a model with Canadian data. Both theoretical models and empirical findings point to the possibility of non-linear relationships between monetary policy, financial stress, and the real economy. The research indicates that when the economy can move into different regimes of financial stress, monetary policy can influence the likelihood of moving from one regime to another. It also implies that monetary policy actions have stronger effects when financial stress is high and that the tightening of monetary policy appears to have more powerful effects than easing.