Financial Factors: Implications for Output Gaps

Abstract

We suggest a new approach for analyzing the role of financial variables and shocks in computing the output gap. We estimate a two-region DSGE model for the euro area, with financial frictions at the household level, between 2000-2013. After joining the monetary union, a decline in some countries' borrowing costs contributed to a credit, housing and real boom and bust cycle. We show that financial frictions amplified economic fluctuations and the measure of the output gap in those countries. On the contrary, in countries such as France and Germany, financial frictions played a minor role in output gap measures. We also present evidence of the trade-offs faced by the European Central Bank when trying to stabilize two regions in a currency union with unsynchronized economic cycles.

Output Gap, Monetary Policy Trade-Offs and Financial Frictions

“…Extending our analysis to alternative models with di¤erent kinds of …nancial frictions seems of paramount importance for monetary policy analysis. A …rst step in that direction has been taken by Rabanal and Taheri Sanjani (2015). Second, our estimated conventional output gap (but also the Monetary Policy Score) features an important low frequency component and exhibits a large magnitude.…”

Interaction of Labour and Credit Market in Growth Regimes: A Theoretical and Empirical Analysis

“…() and Borio () demonstrates, however, the high co‐variation of credit growth and GDP growth, throwing new light on how output growth interacts with the credit markets. This work has been extended to also consider interactions between credit and labour markets (see, for instance, Rabanal and Sanjani, ).…”

“…() and Borio () demonstrates, however, the high co‐variation of credit growth and GDP growth, throwing new light on how output growth interacts with the credit markets. This work has been extended to also consider interactions between credit and labour markets (see, e.g., Rabanal and Sanjani, ). By now considering linkages between output and credit cycles has become the new standard in the macroeconomics literature, with growth cycles expressed by periods of high and low GDP growth, and financial market cycles expressed by such variables as credit flows, leveraging, banking and security market variables, credit spreads, risk premia and so on.…”

Steady as She Goes-Estimating Potential Output During Financial 'Booms and Busts'

“…where L t R is the lending rate, t R is the deposit rate, and the risk shock w t  follows an autoregressive process of order one. Everything else constant, house price increases lower loan-to-values and the default rate, which reduces the lending rate for borrowers, who will 1 The model is described in full in Rabanal and Taheri Sanjani (2015).…”

“…They find that sustainable growth, defined as output growth that does not widen macroeconomic imbalances, is more stable than conventional measures of potential growth, resulting in an output gap that is substantially larger (in absolute value) both before and after the crisis.10 See Section III. The model is described in greater detail inRabanal and Taheri Sanjani (2015).©International Monetary Fund. Not for Redistribution…”