The credit channel during times of financial stress: A time varying VAR analysis

This paper investigates in the contribution of financial stress to gdp and price developments as well as in the strength of the credit channel, as part of the monetary policy transmission mechanism, especially in times of high financial stress. Therefore, a TVP VAR with stochastic volatility is estimated and a structural financial stress shock, a monetary policy shock and a productivity shock are identified by using sign restrictions. Moreover, the imposed identification relies on a monetary DSGE model with financial frictions in the form of moral hazard with bankers running away with a faction of the assets they manage. As the estimation sample spans from 1984Q1 to 2012Q4 the implied impulse responses of the model are verified by re-simulating the model over a wide range of parameter calibrations as to account for a decline of inflation persistence and changing monetary policy as well as changes in the risk-adjusted premium and leverage ratio of the financial intermediaries over time. It is shown that structural financial stress as well as monetary policy shock are drivers of real economic activity and prices. Especially during the recent financial crisis and also in the course of the dot-com crisis financial stress has had negative impacts on gdp and prices whereas monetary policy was able to counteract declines of gdp but was not able to offset deflationary developments. The contributions to the risk-adjusted financing premium show that the credit channel in deed has been of increased importance during times of high financial stress. Thus, the paper provides evidence for the implications of recently developed DSGE models with financial frictions in the banking sector.