Vector STAR , financial stress , financial cycle , real economy , regimeswitching , euro area
Abstract:
We analyze the feedback mechanisms between economic downturns and financial
stress for euro area countries. Our study employs newly constructed financial
condition indices that incorporate extensively banking variables. We apply a nonlinear
Vector Smooth Transition Autoregressive (VSTAR) model for investigating
instabilities in the financial sector-output linkages. The VSTAR model appears appropriate
since it allows for smooth regime changes and asymmetric dynamics. We
find that regime-switching takes place rather smoothly which dampens the negative
output response after a shock in the financial sector in the selected euro area countries.
Moreover, linearity cannot be rejected for all countries over some extensive
time period questioning non-linearities in the financial sector-output nexus as unambiguous
feature. In particular, we show that the negative effect of financial stress
on output typically observed is not always present. This holds specifically for the
time before the Lehman collapse, even if this is a model-defined high stress regime.
After the collapse, we observe strong amplification mechanisms. This suggests that
events leading to a strong economic breakdown are rare but large events and related
to financial cycles which exhibit low frequency.
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