Published online by Cambridge University Press: 09 June 2017
The recent global financial crisis and the subsequent recession have revitalized the discussion on causal interactions between financial and economic sectors. In this study, I apply the financial stress and the national activity indices–respectively developed by Federal Reserve Banks of Kansas City and Chicago–to investigate the impact of financial uncertainty on an overall economic performance. I examine nonlinear dynamics in a vector smooth transition autoregressive framework, and illustrate regime-dependent asymmetries in the financial and economic indices using the generalized impulse-response functions. The results reveal more amplified dynamics during the stressed conditions. I further evaluate benefits of nonlinear modeling in an out-of-sample setting. The forecasting exercise brings out the important advantages that nonlinear modeling provides in the identification of the causal effect of financial instability on overall economic performance.
This paper greatly benefited from many useful comments and suggestions from Edward Nelson, as well as those of two anonymous referees.