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Monetary policy shocks and financial conditions: A Monte Carlo experiment

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  • Castelnuovo, Efrem

Abstract

The effects of monetary policy shocks on financial conditions are often estimated by appealing to recursive Vector AutoRegressions (VARs). We assess the ability of this class of VARs to recover the true effects of a monetary policy shock via a Monte Carlo experiment in which the Data Generating Process is a Dynamic Stochastic General Equilibrium (DSGE) model featuring macro-finance interactions and estimated with U.S. quarterly data. Our DSGE model predicts a negative and significant reaction of financial conditions to an unexpected monetary policy tightening. We point out that such reaction is just overlooked by recursive VARs. Moreover, we show that Cholesky-VARs may substantially underestimate the welfare costs due to macroeconomic fluctuations.

Suggested Citation

  • Castelnuovo, Efrem, 2013. "Monetary policy shocks and financial conditions: A Monte Carlo experiment," Journal of International Money and Finance, Elsevier, vol. 32(C), pages 282-303.
    • Handle: RePEc:eee:jimfin:v:32:y:2013:i:c:p:282-303
    DOI: 10.1016/j.jimonfin.2012.04.011
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    6. Helmut Herwartz & Alexander Lange & Simone Maxand, 2022. "Data‐driven identification in SVARs—When and how can statistical characteristics be used to unravel causal relationships?," Economic Inquiry, Western Economic Association International, vol. 60(2), pages 668-693, April.
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    9. Koop, Gary & Korobilis, Dimitris, 2014. "A new index of financial conditions," European Economic Review, Elsevier, vol. 71(C), pages 101-116.
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    More about this item

    Keywords

    Kansas City Financial Stress Index; Financial–macroeconomic interactions in a DSGE model; Monetary policy shock; Cholesky-VARs; Monte Carlo exercises;
    All these keywords.

    JEL classification:

    • E32 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Business Fluctuations; Cycles
    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy

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