The real effects of financial stress in the Euro zone

Abstract

Using two identification strategies based on a Bayesian Structural VAR and a Sign-Restriction VAR, we examine the real effects of financial stress in the Eurozone. In particular, we assess the macroeconomic impact of: (i) a monetary policy shock; and (ii ) a financial stress shock. We find that a monetary policy contraction strongly deteriorates financial stress conditions. In addition, unexpected variation in the Financial Stress Index (FSI) plays an important role in explaining output fluctuations, and also demands an aggressive response by the monetary authority to stabilise output indicating a preference shift from targeting inflation as it is currently happening in major economies. Therefore, our paper reveals the importance of adopting a vigilant posture towards financial stress conditions, as well as the urgency of macro-prudential risk management.