Financial Depth and the Asymmetric Impact of Monetary Policy
| Published date | 01 December 2017 |
| Author | Ozge Kandemir Kocaaslan,Mustafa Caglayan,Kostas Mouratidis |
| DOI | http://doi.org/10.1111/obes.12160 |
| Date | 01 December 2017 |
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©2017 The Department of Economics, University of Oxford and JohnWiley & Sons Ltd.
OXFORD BULLETIN OF ECONOMICSAND STATISTICS, 79, 6 (2017) 0305–9049
doi: 10.1111/obes.12160
Financial Depth and the Asymmetric Impact of
Monetary Policy
Mustafa Caglayan*, Ozge Kandemir Kocaaslan† and Kostas
Mouratidis‡
*School of Social Sciences, Heriot–Watt University, Edinburgh, EH14 4AS, UK (e-mail:
m.caglayan@hw.ac.uk)
†Department of Economics, Hacettepe University, Beytepe Yerle¸skesi, 06800 C¸ankaya-
Ankara, Turkey (e-mail: ozge.kandemir@hacettepe.edu.tr)
‡Department of Economics, University of Sheffield, Sheffield, S1 4DT, UK (e-mail: k.mou
ratidis@sheffield.ac.uk)
Abstract
This paper investigates the importance of financial depth in evaluating the asymmetric
impact of monetary policy on real output over the course of the US business cycle.We show
that monetary policy has a significant impact on output growth during recessions. We also
show that financial deepening playsan important role by dampening the effects of monetary
policy shocks in recessions. The results are robust to the use of alternative financial depth
and monetary policy shock measures as well as to two different sample periods.
I. Introduction
There is a vast body of empirical literature which examines the effects of monetary policy
on the real economy. Several researchers in monetary economics have claimed that the
impact of monetary policy on the real economy varies over the course of the business
cycle. For instance, some researchers, referring to sticky prices and nominal wages, re-
late the asymmetry to the sign of the monetary policy shocks.1Others have argued, on
the basis of menu cost models, that the impact of monetary policy depends on the size of
the shock rather than the sign.2Still others, referring to the credit channel, suggest that the
asymmetry of monetary policy shocks relates to the state of the business cycle.3
There is also a long and well-established research in macroeconomics that shows
credit market imperfections play a significant role in magnifying output fluctuations.4The
JEL Classification numbers: E32, E52.
1See for instance, Cover (1992), DeLong and Summers (1988) and Karras (1996).
2See for instance, Ball and Romer (1990), Ball and Mankiw (1994) and Ravn and Sola (2004).
3Among others see, for example, Garcia and Schaller (2002), Lo and Piger (2005) and Dolado and Mar´ıa-Dolores
(2006).
4See, for example, Bernanke and Gertler (1989), Bernanke, Gertler and Gilchrist (1996, 1999) . Also see Levine
(2005) and Papaioannou (2007) for detailed surveys of this literature.
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literature claims that financial market distortions create a powerful source of propagation
by means of a financial accelerator mechanism; that is, an unanticipated adverse (mone-
tary) shock would decrease not only the demand for capital but also the firms’ net worth,
thereby inducing a further drop in investment and output. Research, therefore, suggests that
an economy with deeper financial markets could mitigate the adverse effects of shocks, as
innovativefirms could continue to draw funds from potential lenders even during economic
downturns.
In this paper, we empirically investigate whether monetary policy has asymmetric ef-
fects over the course of the business cycle, and the extent to whichfinancial frictions affect
the transmission of monetary policy shocks as the economy evolves. Earlier research that
has examined the asymmetric effects of monetary policy during booms vs. recessions was
unclear as to whether asymmetries were driven by the convexity of the supply curve or
by financial market frictions. The empirical framework proposed here allows us to iden-
tify directly both whether financial market frictions affect the transmission of monetary
policy shocks and whether financial deepening mitigates the adverse effects of shocks as
the financial accelerator mechanism suggests.5To carry out our investigation, we augment
our model with an interaction term between monetary policy shock and financial depth
measures, which acts as a proxy of financial frictions, and estimate the resulting model
by an instrumental variable Markov regime switching (MRS) framework, as suggested by
Spagnolo, Psaradakis and Sola (2005). This framework allows us to examine the asymmet-
ric effects of monetary policy shocks in conjunction with the role that financial depth plays,
while the instrumental variable approach helps us to overcome endogeneity problems that
may exist in our model.
Our investigation utilizes two separate financial depth measures. Our first measure is
defined as the ratio of credits by financial intermediaries to the private sector with respect
to GDP. The second measure is the ratio of claims on the non-financial private sector to
total domestic credit (excluding credit to money banks). To gauge the effects of monetary
policy shocks on real output, we have used three proxies. First, we follow a conventional
approach to measuring monetary policy shocks by using the actual changes in the Federal
funds rate as a policy measure.6However, Romer and Romer (2004) have shown that
the actual changes in the Federal funds rate could underestimate the impact of monetary
policy on output growth, as this measure may have been contaminated by the endogenous
movements of the interest rate and the expected actions of the Federal Reserve (Fed). To
address these difficulties, Romer and Romer (2004) proposed an alternative measure by
regressing the intended fund rate changes on the Fed’s internal forecast of inflation and
of real economic activity. In our case, rather than directly implementing the model that
Romer and Romer (2004) used to generate monetary policy shocks, we modify it such that
in one case the model’s parameters are allowed to be time-variant and in the other case the
parameters are allowed to be time-varying with regime switching. This modification to the
original model was essential because there is substantial evidence that monetary policy has
5Peersman and Smets (2005), using industry level data from seven Euro area countries, implement a two step
modelling approach in order to provide support for the financial accelerator mechanism. However, they do not
examine how changes in financial deepening affect the asymmetries in monetary policy overthe business cycle.
6See, for instance, Garcia and Schaller (2002).
©2017 The Department of Economics, University of Oxford and JohnWiley & Sons Ltd
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