Does Financial Stress Have an Impact on Monetary Policy? : An Econometric Analysis Using Norwegian Data

Abstract

This thesis investigates the impact of financial stress on monetary policy in Norway. Financial distress has a negative impact on the economy, and if the shocks are large enough, it may possibly lead to a recession in the economy with sustained deflationary pressure, low production and high unemployment rates. The manner and extent to which the central bank reacts to counteract the effects of financial stress may thus be key in avoiding longer spells of reductions in the economic growth of a country. This thesis will investigate the impact of financial stress on the monetary policy decisions in Norway– both how large the effect has been and whether the central bank has responded ex ante or ex post to financial stress.

The effect of financial stress on the monetary policy is estimated using an augmented Taylor rule using monthly data from 1998 to 2011. All regressors are treated as endogenous in a model framework where the parameter capturing the effect of financial instability is time varying. The results show a negative relationship between financial instability and monetary policy decisions. That is, the estimation results imply that an increase in the financial stress index contributes to lower interest rates. The effect is found to be larger in late 2008, when a full-blown financial crisis hit the global economy, than during the rest of the period covered by my sample. Furthermore, the estimates suggest that the central bank reacted more aggressively after an increase in financial stress had occurred than before such an increase.