Financial Cycle, Business Cycle and Monetary Policy: Evidence from Four Major Economies

• Author: Jinglan Zhang,Yong Ma
• Published date: 01 October 2016
• DOI: http://doi.org/10.1002/ijfe.1566
• Date: 01 October 2016

FINANCIAL CYCLE, BUSINESS CYCLE AND MONETARY POLICY:

EVIDENCE FROM FOUR MAJOR ECONOMIES

YONG MA*

,†

and JINGLAN ZHANG

China Financial Policy Research Center, School of Finance, Renmin University of China, No. 59 Zhong Guan Cun Street, Haidian District,

Beijing 100872, China

ABSTRACT

Economists used to think that financial factors are not important in the business cycle, but the 2008 global financial crisis has

made it apparent that financial cycle plays a much larger role in macroeconomic dynamics than anticipated. Against this

background, economists endeavor to introduce financial factors into macroeconomic models. In this paper, we incorporate

financial cycle into a four-equation model to study the linkages and interactions between financial cycle, business cycle and

monetary policy. The results suggest that financial cycle plays a significant role in the business cycle, and that financial cycle

shock has become a main driving force for macroeconomic fluctuations, especially during times of financial instability. In

addition, by comparing the performance of the finance-augmented Taylor rule with that of the conventional Taylor rule, we find

that both the financial system and the real economy will be better stabilized under the finance-augmented Taylor rule. This result

adds new evidence to the argument that monetary policy has an important role in safeguarding the financial system and that

financial stability should be adopted as a target for monetary policy. Copyright © 2016 John Wiley & Sons, Ltd.

Received 15 August 2015; Revised 09 July 2016; Accepted 13 September 2016

JEL CODE: E32; E37; E52

KEY WORDS: Financial cycle; business cycle; financial stability; monetary policy

1. INTRODUCTION

The role of financial cycle in business cycle fluctuations has long been a subject of study. Yet, most of the tradi -

tional literature on business cycles relies heavily on macroeconomic models that ignore financial factors. In this

context, the optimal monetary policy rules would then involve no financial considerations. However, the 2008

global financial crisis, which clearly showed that dangerous and macro-relevant financial imbalances could be

intensified even under stable output growth and low inflation, has challenged the existing theory and has escalated

the discussion on the role of financial factors in business cycle fluctuations and whether monetary policy should

take into account financial imbalances.

In the three decades preceding the crisis, business cycle studies are mainly based on the real business cycle

(RBC) models or the New Keynesian models that abstract from financial sector activity (e.g. Kydland and Prescott,

1982; Long and Plosser, 1983; Woodford, 2003). These studies focus primarily on the dynamics of real variables

such as GDP, prices, consumption and employment. Even money and interest rates are sometimes omitted in such

models. However, this does not simply mean that economists have disregarded financial considerations in shaping

their thoughts on macroeconomic activity. Important works such as Schumpeter (1934), Gurley and Shaw (1955),

Tobin and Brainard (1963), Minsky (1975) and Kindleberger (1978) have emphasized the relationship between

financial cycle and the business cycle. In the 1980s, new empirical work and new developments in theory rekindled

*Correspondence to: Yong Ma, School of Finance, Renmin University of China, No. 59 Zhong Guan Cun Street, Haidian District, Beijing

100872, China.

†

E-mail: mayong19828@hotmail.com; mayongmail@ruc.edu.cn

Copyright © 2016 John Wiley & Sons, Ltd.

International Journal of Finance & Economics

Int. J. Fin. Econ. 21: 502–527 (2016)

Published online in Wiley Online Library

(wileyonlinelibrary.com). DOI: 10.1002/ijfe.1566

interest in studying financial aspects of the business cycle (Gertler, 1988). For example, Scheinkamn and Weiss

(1986) demonstrate how borrowing constraints at the individual level can lead to cycles in the aggregate

behavior. Bernanke and Gertler (1986) provide a framework in which endogenous procyclical movements in

entrepreneurial net worth magnify investment and output fluctuations. In another paper, Bernanke and Gertler

(1987) develop a model of banking and macroeconomic behavior to demonstrate the significance of financial

health of the banking sector on the macroeconomy. Another important framework for incorporating financial

sectors uses the financial accelerator (FA) model, as developed in Kiyotaki and Moore (1997) and Bernanke

et al. (1999). These models tend to show that the presence of asymmetric information in financial markets

can give the balance sheet conditions of borrowers a role to play in the business cycle through their impact

on the cost of external finance. As a result, ‘financial frictions’arising from the procyclical nature of net worth

may significantly amplify the magnitude and the persistence of fluctuations in economic activity. This modeling

strategy has been extensively adopted in subsequent studies such as Gilchrist et al. (2002), Céspedes et al.

(2002), Decereux et al. (2005), Iacoviello (2005), Gertler et al. (2007), Christensen and Dib (2008) and Meh

and Moran (2010), among many others.

In spite of relatively ample literature on the financial business cycles, the analysis of financial shocks as a

‘source’of business cycle fluctuations has received less attention in the literature before the crisis. In fact, following

the RBC literature, the conventional view about the sources of the business cycle has been centered primarily on

technology shocks (TFP). After the crisis, however, the view regarding the sources of the business cycle has

expanded to include financial shocks. For example, Christiano et al. (2010) introduce financial frictions and finan-

cial shocks into an otherwise standard monetary equilibrium model and find that financial shocks motivated by the

BGG frictions account for a substantial portion of economic fluctuations in the Euro Area and in the United States.

Similarly, Hafstead and Smith (2012) extend the BGG model by introducing bank production functions that imply

a positive marginal cost for banks to originate loans and accept deposits; they find that financial shocks, both on the

demand and supply sides, can cause severe macroeconomic fluctuations. In another paper, Jermann and Quadrini

(2012) develop a model with debt and equity financing to explore the macroeconomic effects of financial shocks

and find that financial shocks contributed significantly to the observed dynamics of real and financial variables.

Similar conclusions are also reported in other related studies (e.g. Gertler and Kiyotaki, 2010; Hirakata et al.,

2011). In a recent study, Caldara et al. (2014) find that financial shocks have a significant adverse effect on eco-

nomic outcomes and that such shocks were an important source of cyclical fluctuations since the mid-1980. Based

on the core idea that business cycles are financial rather than real, Iacoviello (2015) estimates a dynamic stochastic

general equilibrium (DSGE) model where a recession is initiated by losses suffered by banks, which finds that

redistribution and other financial shocks that affect leveraged sectors accounts for two-thirds of the output

collapsed during the Great Recession. In line with this idea, recent contributions by Nolan and Thoenissen

(2009); Mandelman (2010); Ajello (2014); Liu et al. (2011), and Christiano et al. (2013) also consider shocks that

originate in the financial sector and suggest that these shocks could play an important role as a source of business

cycle fluctuations.

Overall, the abundance of theoretical as well as empirical studies, particularly those after the 2008 global finan-

cial crisis, has strongly argued the linkages and interactions between financial cycle and business cycle. This has

led to an increasing consensus among economists that financial cycle plays an important role as a source of busi-

ness cycle fluctuations. It also raises the question of whether monetary policy should take into account financial

stability objectives. Among the authors that are in favor of this idea, White (2009) and Woodford (2012) argue that

price stability is a necessary but insufficient condition for financial stability, and central banks should actively use

the interest rate to lean against financial imbalances. Gameiro et al. (2011) conclude that given the importance of

the financial system in the monetary policy transmission mechanism, achieving financial stability should also be a

priority for monetary policy. Claessens et al. (2012) argue that, in light of the multidimensional interactions

between financial and business cycles, close monitoring of financial cycles should be an integral part of macroeco-

nomic surveillance and policy design. It is necessary to adopt strategies that allow central banks to tighten so as to

lean against the build-up of financial imbalances even if near-term inflation remains subdued (e.g. Caruana, 2011;

Eichengreen et al., 2011). This implies raising interest rates more than conventional Taylor rules would be called

for (Taylor, 2010). Erdem and Tsatsaronis (2013) investigate the linkages between financial and real variables that

are revealed by pure statistical techniques. Their results suggest that financial variables have significant information

FINANCIAL CYCLE, BUSINESS CYCLE AND MONETARY POLICY 503

Copyright © 2016 John Wiley & Sons, Ltd. Int. J. Fin. Econ. 21: 502–527 (2016)

DOI: 10.1002/ijfe