Fiscal-Monetary-Financial Stability Interactions in a Data-Rich Environment

Issue: 3/2018

Lukáš Pfeifer

University of Economics in Prague, Department of Monetary Theory and Policy, 1938/4 W. Churchill Sq., 130 67 Prague 3, Czech Republic, e-mail:

Martin Hodula

VŠB-Technical University of Ostrava, Economic Faculty, Department of Economics, Sokolská třída 33, 701 21 Ostrava, Czech Republic, e-mail:

In this paper, we shed some light on the mutual interplay of economic policy and the financial stability objective. We contribute to the intense discussion regarding the influence of fiscal and monetary policy measures on the real economy and the finan-cial sector. We apply a factor-augmented vector autoregression model to Czech macroeconomic data and model the policy interactions in a data-rich environment. Our findings can be summarized in three main points: First, loose economic policies (especially monetary policy) may translate into a more stable financial sector, albeit only in the short term. In the medium term, an expansion-focused mix of monetary and fiscal policy may contribute to systemic risk accumulation, by substantially increasing credit dynamics and house prices. Second, we find that fiscal and monetary policy impact the financial sector in differential magnitudes and time horizons. And third, we confirm that systemic risk materialization might cause significant output losses and deterioration of public finances, trigger deflationary pressures, and increase the debt service ratio. Overall, our findings provide some empirical support for countercyclical fiscal and monetary policies.

DOI: 10.2478/revecp-2018-0012
JEL: G28, E61, E44
Keywords: policy mix, monetary policy, macroprudential policy, Interactions, Fiscal Policy, financial stability

AASTVEIT, K. A. (2013). Oil price shocks and monetary policy in a data-rich environment. Working paper series 10/2013, Norges Bank (Central Bank of Norway).

AASTVEIT, K., FURLANETTO, F., & LORIA, F. (2017). Has the fed responded to house and stock prices? A time-varying analysis. Working paper series 01/2017, Norges Bank (Central Bank of Norway).

ABBATE A., & THALER, D. (2015). Monetary policy and the asset risk-taking channel. Discussion paper 48/2015, Deutsche Bundesbank.

ADRIAN, T., & LIANG, N. (2016). Monetary policy, financial conditions, and financial stability. Staff report 690, Federal Reserve Bank of New York.

AGNELLO, L., & SOUSA, R. M. (2009). The determinants of public deficit volatility. Working paper 1042, European Central Bank.

AGNELLO, L., & SOUSA, R. M. (2013). Fiscal policy and asset prices. Bulletin of Economic Research, 65(2), 154-177. DOI: 10.1111/j.0307-3378.2011.00420.x

AMBRISKO, R., BABECKY, J., RYSANEK, J., & VALENTA, V. (2015). Assessing the impact of fiscal measures on the Czech economy. Economic Modelling, 55(1), 350-357. DOI: 10.1016/j.econmod.2014.07.021

ANDREWS, D., CALDERA SÁNCHEZ, A., & JOHANSSON, A. (2011). Housing markets and structural policies in OECD countries. Economics department working papers 836, OECD.

ANGELONI, I., FAIA, E., & LO DUCA, M. (2017). Monetary policy and risk taking. Journal of Economic Dynamics & Control, 52, 285-307. DOI: 10.1016/j.jedc.2014.12.001

ARI, A. (2016). Sovereign risk and bank risk-taking. Working paper series 1894/2016, European Central Bank.

AYDIN, B., & VOLKAN, E. (2011). Incorporating financial stability in inflation targeting framework. Working paper 11/224, International Monetary Fund.

BABECKY, J., HAVRANEK, T., MATEJU, J., RUSNAK, M., SMIDOVA, K., & VASICEK, B. (2013). Leading indicators of crisis incidence: evidence from developed countries. Journal of International Money and Finance, 35, 1-19. DOI: 10.1016/j.jimonfin.2013.01.001

BERNANKE, B., BOIVIN, J., & ELIAZS, P. (2005). Measuring the effects of monetary policy: a factor-augmented vector autoregressive (FAVAR) approach. The Quarterly Journal of Economics, 120 (1), 387-422.

BIANCHI, F., & ILUT, C. (2017). Monetary/fiscal policy mix and agent's beliefs. Review of Economic Dynamics, 26, 113-139. DOI: 10.1016/

BANK FOR INTERNATIONAL SETTLEMENTS (2016). Towards a financial stability-oriented fiscal policy. Basel: Bank for International Settlements.

BLANCHARD, O., & PEROTTI, R. (2002). An empirical characterization of the dynamic effects of changes in government spending and taxes on output. The Quarterly Journal of Economics, 117(4), 1329−1368. DOI: 10.1162/003355302320935043

BORIO, C. (2014a). The financial cycle and macroeconomics: what have we learnt? Journal of Banking & Finance, 45(1), 182–98. DOI: 10.1016/j.jbankfin.2013.07.031

BORIO, C. (2014b). The international monetary and financial system: its Achilles heel and what to do about it. Working Paper 456, Bank for International Settlements.

BORIO, C. (2016). Revisiting three intellectual pillars of monetary policy. Cato Journal, 36(2), 213-238.

BORIO, C. (2017). Secular stagnation or financial cycle drag? Business Economics, 52(2), 87-98. DOI: 10.1057/s11369-017-0035-3

BORIO, C., & Lowe, P. (2002). Asset prices, financial and monetary stability: exploring the nexus. Working paper 114, Bank for International Settlements.

BORIO, C., DISYATAT, P., & JUSELIUS, M. (2013). Rethinking potential output: embedding information about the financial cycle. Working Paper 404, Bank for International Settlements.

BORIO, C., KHARROUBI, E., UPPER, Ch., & ZAMPOLLI, F. (2015). Labour reallocation and productivity dynamics: financial causes, real consequences. Working Paper 534, Bank for International Settlements.

BORIO, C., & ZHU, H. (2012). Capital regulation, risk-taking and monetary policy: a missing link in the transmission mechanism? Journal of Financial Stability, 8(4), 236-251. DOI. 10.1016/j.jfs.2011.12.003

BORYS, M., FRANTA, M., & HORVATH, R. (2009). The effects of monetary policy in the Czech Republic: an empirical study. Empirica, 36(1), 419-443. DOI: 10.1007/s10663-009-9102-y

CARLSTROM, Ch, FUERST, T., & PAUSTIAN, M. (2010). Optimal monetary policy in a model with agency costs. Journal of Money, Credit and Banking, 42(6), 37-70. DOI: 10.1111/j.1538-4616.2010.00329.x

DEEV, O., & HODULA, M. (2016). Sovereign default risk and state-owned bank fragility in emerging markets: evidence from China and Russia. Post-Communist Economies, 28(2), 232-248. DOI: 10.1080/14631377.2016.1164438

DREHMANN, M., & JUSELIUS, M. (2012). Do debt service costs affect macroeconomic and financial stability? BIS Quaterly Review, September 2012, 21-35.

DREHMANN, M., BORIO, C., & TSATSARONIS, K. (2012). Characterizing the financial cycle: don't lose sight of the medium term! Working Paper 380, Bank for International Settlements.

DUNGEY, M., & FRY, R. (2009). The identification of fiscal and monetary policy in a structural VAR. Economic Modelling, 26(6), 1147-1160. DOI: 10.1016/j.econmod.2009.05.001

EDGE, R. M., & MEISENZAHL, R. R. (2011). The unreliability of Credit-to-GDP ratio gaps in real time: implications for countercyclical capital buffers. International Journal of Central Banking, 7(4), 261-298.

EICKMEIER, S. & HOFMANN, B. (2013). Monetary policy, housing booms and financial (im)balances. Macroeconomic Dynamics, 17(4), 830-860. DOI: 10.1017/S1365100511000721

ESCHENBACH, F., & SCHUNKNECHT, L. (2004). The fiscal costs of financial instability revisited. Economic Policy, 14(1), 313-346.

ESRB (2016). Macroprudential policy beyond banking: an ESRB strategy paper. Frankfurt am Main: European System Risk Board.

FILARDO, A., & RUNGCHAROENKITKUL, P. (2016). A quantitative case for leaning against the wind. Working Paper 594, Bank for International Settlements.

FORNI, M., & GAMBETTI, L. (2010). The dynamic effects of monetary policy: A structural factor model approach. Journal of Monetary Economics, 57(1), 203−216. DOI: 10.1016/j.jmoneco.2009.11.009

FRANTA, M. (2012). Macroeconomic effects of fiscal policy in the Czech Republic: evidence based on various identification approaches in a VAR framework. Working Paper 13/2012, Czech National Bank.

GALATI, G. & MOESSNER, R. (2013) Macroprudential policy – a literature review. Journal of Economic Surveys 27(5), 846-878.

GALÍ, J., & GAMBETTI, L. (2015) The effects of monetary policy on stock market bubbles: some evidence. American Economic Journal: Macroeconomics, 7(1), 233–57.

GERSL, A., & SEIDLER, J. (2015). Countercyclical capital buffers and Credit-to-GDP gaps: simulation for central, eastern, and southeastern Europe. Eastern European Economics, 53(6), 439-465. DOI: 10.1080/00128775.2015.1102602

GILBERT C., LEVIEUGEA, G., & POPESCU, A. (2018). Monetary policy and long-run systemic risk-taking. Journal of Economic Dynamics and Control, 86, 165-184. DOI: 10.1016/j.jedc.2017.11.001

GOODHART, C. (2001). What Weight Should Be Given to Asset Prices in the Measurement of Inflation? The Economic Journal, 111(472), 335-356. DOI: 10.1111/1468-0297.00634

GRAMLICH, D., Miller, G. L., OET, M. V., & ONG, S. J. (2010). Early warning systems for systemic banking risk: critical review and modeling implications. Banks and Bank Systems, 5(2), 199-211.

HALLETT, A. H., & LEWIS, J. (2008). European fiscal discipline before and after EMU: crash diet or permanent weight loss? Macroeconomic Dynamics, 12(3), 404–24. DOI: 10.1017/S1365100507070204

HAMILTON, J. D. (2017, in press). Why you should never use the Hodrick-Prescott filter. Review of Economics and Statistics. DOI: 10.1162/REST_a_00706

HAMPL, M., & HAVRANEK, T. (2017). Should inflation measures used by central banks incorporate house prices? the Czech National Bank’s approach. Research and Policy Note 1/2017, Czech National Bank.

HAUG, A., JEDRZEJOWIC, T., & SZNAJDERSKA, A. (2013). Combining monetary and fiscal policy in an SVAR for a small open economy. Working Paper 168, Narodowy Bank Polski (Central bank of Poland).

HODULA, M., & PFEIFER, L. (2018). The impact of credit booms and economic policy on labour productivity: a sectoral analysis. Acta VŠFS, 12(1), 10‒42.

HOFFMAN, B., & PEERSMAN, G. (2017). Is there a debt service channel of monetary transmission? BIS Quarterly Review, December 2017, 23-37.

IMF (2015). Monetary policy and financial stability. Washington: International Monetary Fund.

IWATA, Y. (2013). Two fiscal policy puzzles revisited: new evidence and an explanation. Journal of International Money and Finance, 33(C), 188−207. DOI: 10.1016/j.jimonfin.2012.11.015

JUSELIUS, M., BORIO, C., DISYATAT, P., & DREHMANN, M. (2017). Monetary policy, the financial cycle, and ultra-low interest rates. International Journal of Central Banking, 13(3), 55–90.

KILIAN, L. (1988). Small-sample confidence intervals for impulse response functions. Review of Economics and Statistics, 80 (2), 218-230.  DOI: 10.1162/003465398557465

KUTTNER, K. N. (2013). Low interest rates and housing bubbles: still no smoking gun. In Douglas D. Evanoff et al. (ed.), The Role of Central Banks in Financial Stability, pp. 218-230. Singapore: World Scientific Publishing.

LAEVEN, L., & VALENCIA, F. (2010). Resolution of banking crises: the good, the bad, and the ugly. Working Paper 146, International Monetary Fund.

LAEVEN, L., & VALENCIA, F. (2013). Systemic banking crises database. IMF Economic Review, 61(2), 225-270. DOI: 10.1057/imfer.2013.12

LAGANA, G., & SGRO, P. M. (2011). A factor-augmented VAR approach: the effect of a rise in the US personal income tax rate on the US and Canada. Economic Modelling, 28(3), 1163-1169. DOI: 10.1016/j.econmod.2010.12.007

LAINA, P., NYHOLM, J., & SARLIN, P. (2015). Leading Indicators of Systemic Banking Crises: Finland in a panel of EU countries. Working paper 1758, European Central Bank.

LEEPER, E. M. (1991). Equilibria under active and passive monetary policies. Journal of Monetary Economics, 27(1), 129-147. DOI: 10.1016/0304-3932(91)90007-B

LIBICH, J. (2017). Unpleasant monetarist arithmetic: macroprudential edition. Working Paper 2017-40, Centre for Applied Macroeconomic Analysis.

LOMBARDI, M., MOHANTY, M., & SHIM, I. (2017). The real effects of household debt in the short and long run. Working Paper 607, Bank for International Settlements.

MALOVANÁ, S., & FRAIT, J. (2017). Monetary policy and macroprudential policy: rivals or teammates? Journal of Financial Stability, 32, 1-16. 10.1016/j.jfs.2017.08.004

MOUNTFORD, A., & UHLIG, H. (2009). What are the effects of fiscal policy shocks? Journal of Applied Econometrics, 24(6), 960-992. 10.1002/jae.1079

MUSCATELLI, V.A., TIRELLI, P., & TRECROCI, C. (2004). Fiscal and monetary policy interactions: empirical evidence and optimal policy using a structural New Keynesian model. Journal of Macroeconomics, 26, 257-280. DOI: 10.1016/j.jmacro.2003.11.014

OBSTFELD, M., & ROGOFF, R. (2009). Global imbalances and the financial crisis: Products of common causes. Econometrics laboratory. Discussion Paper 7606, Centre for Economic Policy Research.

ORPHANIDES, A. (2017). The fiscal-monetary policy mix in the euro area: challenges at the zero lower bound. Discussion Paper 060, European Commission.

PAUL, P. (2018). The Time-Varying Effect of Monetary Policy on Asset Prices. Working Paper 2017-09, Federal Reserve Bank of San Francisco.

PLASIL M., KONECNY, T., SEIDLER, J., & HLAVAC, P. (2015). In the quest of measuring the financial cycle. Working Paper 5-2015, Czech National Bank.

REINHART, C. M., & ROGOFF, S. K. (2013). Banking crises: an equal opportunity menace. Journal of Banking & Finance, 37(11), 4557-4573. DOI: 10.1016/j.jbankfin.2013.03.005

ROSSI, B., & ZUBAIRY, S. (2011). What is the importance of monetary and fiscal shocks in explaining U.S. macroeconomic fluctuations? Journal of Money, Credit and Banking, 43(6), 1247-1270. DOI: 10.1111/j.1538-4616.2011.00424.x

SARGENT, T. J., & WALLACE, N. (1991). Some unpleasant monetarist arithmetic. Federal Reserve Bank of Minneapolis Quarterly Review, 5(3), 1-17.

SCHUKNECHT, L., von HAGEN, J., & WOLSWIJK G. (2009). Government risk premiums in the bond market: EMU and Canada. European Journal of Political Economy, 25, 371–84. DOI: 10.1016/j.ejpoleco.2009.02.004

SMETS, F. (2014). Financial stability and monetary policy: how closely interlinked? International Journal of Central Banking, 10(2), 263-300.

STOCK, J. H., & WATSON, M. W. (2002). Forecasting using principal components from a large number of predictors. Journal of the American Statistical Association, 97(460), 1167-1179. DOI: 10.1198/016214502388618960

SVENSSON, L. E. (2016). Cost-benefit analysis of leaning against the wind: Are costs larger with less effective macroprudential policy? Working Paper 16/3, International Monetary Fund.

TAYLOR, J. B. (2009). Economic policy and the financial crisis: an empirical analysis of what went wrong. Critical Review. A Journal of Politics and Society, 21, 341-364.

TUZCUOGLU, K., & HOKE, S. H. (2016). Interpreting the latent dynamic factors by threshold FAVAR model. Working Paper 622, Bank of England.

UEDA, K., & VALENCIA, F. (2014). Central bank independence and macro-prudential regulation. Economics Letters, 125(2), 327-330. DOI: 10.1016/j.econlet.2013.12.038

WOODFORD, M. (1996). Control of the public debt: A requirement for price stability? Working Paper 5684, National Bureau of Economic Research.

WOODFORD, M. (2011). Simple analytics of the government expenditure multiplier. American Economic Journal: Macroeconomics, 3(1), 1-35.