What is the effect of financial stress on economic activity

Despite the apparent risk that financial stress poses to the real economy, the relationship between financial stress and economic activity is complex and not well understood. The experience of the United States and other countries has shown that businesses and households often pull back on new investments and purchases in response to the tighter credit conditions and greater uncertainty caused by financial stress. Yet important gaps remain in our understanding of this critical relationship. ; One potential complication is that the relationship may change when financial stress is elevated and the economy is in a recession. Over the last 20 years, the U.S. economy has shown a tendency to switch between two very distinct states?a normal state in which economic activity is high and financial stress is low, and a distressed state in which economic activity is low and financial stress is high. Does the impact of financial stress on economic activity depend on which of these two states currently prevails? And how do changes in financial stress and economic activity affect the likelihood of switching from one state to the other? ; Davig and Hakkio examine these questions. A key finding is that, over the last two decades, increases in financial stress have had a much stronger effect on the real economy when the economy is in a distressed state. In addition, rising financial stress plays a role in eventually tipping a strong economy into a distressed state. As a result, policymakers should monitor financial conditions closely, both in good as well as bad times.