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Mar 2012

This paper estimates the contribution of financial shocks to fluctuations in the
real economy by augmenting the standard macroeconomic vector
autoregression (VAR) with five financial variables (real stock prices, real
house prices, term spread, loans-to-GDP ratio and loans-to-deposits ratio).
This VAR is estimated separately for 19 industrialised countries over 1980Q1-
2010Q4 using three alternative measures of economic activity: GDP, private
consumption or total investment. Financial shocks are identified by imposing a
recursive structure (Choleski decomposition). Several results stand out. First,
the effect of financial shocks on the real economy is fairly heterogeneous
across countries, confirming previous findings in the literature. Second, the
five financial shocks provide a surprisingly large contribution to explaining real
fluctuations (33% of GDP variance at the 3-year horizon on average across
countries) exceeding the contribution from monetary policy shocks. Third, the
most important source of real fluctuations appears to be shocks to asset
prices (real stock prices account for 12% of GDP variance and real house
prices for 9%). Shocks to the term spread or to leverage (credit-to-GDP ratio
or loans-to-deposits ratio) each contribute an additional 3-4% of GDP
variance. Fourth, the combined contribution of the five financial shocks is
usually higher for fluctuations in investment than in private consumption. Fifth,
historical decompositions indicate that financial shocks provide much more
important contributions to output fluctuations during episodes associated with
financial imbalances (both booms and busts). This suggests possible timevariation
or non-linearities in macrofinancial linkages that are left for future

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