Fiscal-monetary-financial stability interactions in a data-rich environment

Re iew o Economic Pe spec i es – Ná odohospodářský obzo Vol. 18, Issue 3, 2018, pp. 195–223, DOI: 10.2478/ e ecp-2018-0012 © 2018 by he au ho s; licensee Re iew o Economic Pe spec i es / Ná odohospodářský obzo , Masa yk Uni e si y, Facul y o Economics and Adminis a ion, B no, Czech Republic. This a icle is an open access a icle dis ibu ed unde he e ms and condi ions o he C ea i e Commons A ibu ion 3.0 license, A ibu ion – Non Comme cial – No De i a i es. Fiscal-Mone a y-Financial S abili y In e ac ions in a Da a-Rich En i onmen Ma in Hodula, 1 Lukáš P ei e 2 Abs ac : In his pape , we shed some ligh on he mu ual in e play o economic policy and he inancial s abili y objec i e. We con ibu e o he in ense discussion ega ding he in luence o iscal and mone a y policy measu es on he eal economy and he inan- cial sec o . We apply a ac o -augmen ed ec o au o eg ession model o Czech mac oe- conomic da a and model he policy in e ac ions in a da a- ich en i onmen . Ou indings can be summa ized in h ee main poin s: Fi s , loose economic policies (especially mone a y policy) may ansla e in o a mo e s able inancial sec o , albei only in he sho e m. In he medium e m, an expansion- ocused mix o mone a y and iscal poli- cy may con ibu e o sys emic isk accumula ion, by subs an ially inc easing c edi dynamics and house p ices. Second, we ind ha iscal and mone a y policy impac he inancial sec o in di e en ial magni udes and ime ho izons. And hi d, we con i m ha sys emic isk ma e ializa ion migh cause signi ican ou pu losses and de e io a ion o public inances, igge de la iona y p essu es, and inc ease he deb se ice a io. O e - all, ou indings p o ide some empi ical suppo o coun e cyclical iscal and mone a y policies. Key wo ds: inancial s abili y, iscal policy, mac op uden ial policy, mone a y policy, in e ac ions, policy mix JEL Classi ica ion: E44, E61, G28 Recei ed: 20 Ma ch 2018 / Accep ed: 24 May 2018 / Sen o Publica ion: 3 Sep embe 2018 In oduc ion Success ul implemen a ion o mac op uden ial policies equi es, among o he hings, a good unde s anding o he in e play be ween economic policies, hei espec i e a ge s, and inancial sec o de elopmen . In his con ex , he e is an in ense policy deba e o- cused on de e mining he ex en o which iscal and mone a y policy measu es may in luence he unc ioning o he inancial sec o (i.e. he inancial cycle). This deba e has gene a ed in e es in analysing he quan i a i e impo ance o policy ansmission chan- nels o he inancial sec o , hei mu ual coo dina ion, and he implemen a ion o mac o- p uden ial policy ools in smoo hing he inancial cycle. 1 VŠB-Technical Uni e si y o Os a a, Economic Facul y, Depa men o Economics, 15/2172 17. Lis opadu S ., 708 33 Os a a, Czech Republic, e-mail: [email p o ec ed] 2 Uni e si y o Economics in P ague, Depa men o Mone a y Theo y and Policy, 1938/4 W. Chu chill Sq., 130 67 P ague 3, Czech Republic, e-mail: [email p o ec ed]z Re iew o Economic Pe spec i es 196 In his pape , we con ibu e o ha deba e by p esen ing comp ehensi e ime-se ies e idence on he iscal-mone a y-mac op uden ial policy in e ac ions in a da a- ich en i- onmen . We di e om he apidly expanding body o li e a u e on mone a y/ iscal policy and mac op uden ial policy in e ac ions mainly in ha we conside bo h policy shocks simul aneously and iden i y a speci ic policy mix ha migh inc ease sys emic isk in he inancial sec o . Fu he , we also conside he kick-back e ec o inancial ins abili y and analyze i s p opaga ion in he eal economy. In he p ocess, we aim o answe he ollowing ques ions: Fi s , does loose economic policy bene i inancial s abili y? Second, do iscal and mone a y policy shocks impac he inancial sec o di - e en ly? And hi d, how do inancial imbalances in luence eal economic ac i i y? The analysis is conduc ed o he Czech Republic, a small open economy ha wen h ough a ans o ma ion p ocess om a cen ally-planned o a ma ke -based economy in he 1990s. The selec ion o he coun y is pu ely p agma ic; he Czech Republic has a bank- based inancial sec o domina ed by o eign capi al and anks among he mos open economies in Eu ope. A e he Lehman c ash, many o he p e-c isis claims, such as mone a y policy’s ‘be- nign neglec ’ app oach o asse p ice de elopmen o a s ic di ision o labou be ween di e en policy le e s, began o be ques ioned. E en he New Keynesian models, which implied ha ce e is pa ibus p ice s abili y would be a su icien condi ion o ou pu o emain close o i s na u al le el, we e subjec o c i icism. S udies gene ally conclude ( ega ding he p e-c isis de elopmen ) ha he low-in e es - a e en i onmen in he p e- c isis pe iod led o he o ma ion o inancial imbalances while associa ed iscal s imuli du ing c edi booms only deepened sys emic isk (see Taylo , 2009; Obs eld and Rogo , 2009, o policy discussion, o Ad ian and Liang, 2016, o empi ical analysis). The subsequen inancial c isis hen led o de la iona y p essu es and an unp eceden ed (apa om wa ime) inc ease in public deb le els in de eloped coun ies. 3 The in- c ease in so e eign de aul isk u he lowe ed us in deposi insu ance sys ems and, in gene al, educed he abili y o iscal policy o suppo economic g ow h. The e o e, i is only logical o ques ion he ole o economic policy in de e mining economic g ow h and main aining inancial s abili y. A e he c isis, a new se o ools was in oduced o educe he p ocyclical cha ac e o economic policy. I s manda e is o p e en he accumula ion o sys emic isk and he o ma ion o inancial c ises using p uden ially- uned measu es o mac op uden ial policy. In he p esen day, i is becoming ob ious ha iscal, mone a y, and mac op u- den ial policy a ec each o he and a s a egic con lic may a ise in ce ain si ua ions. The e o e, Bo io (2017) claims ha coun e -cyclical economic policy se ings a e now c ucial, as global deb le els a e a a his o ical high poin and oom o policy manoeu- ing is ema kably na ow. In his con ex , achie ing some o m o coo dina ion be- ween economic policy and inancial s abili y objec i es seems o be a undamen al ask. In ac , keeping he inancial sec o s able should be in he bes in e es s o bo h mone- a y and iscal policy, gi en he excessi e cos s o inancial ins abili y. The emainde o he pape is o ganized as ollows: Sec ion 2 se es as a e iew o he li e a u e published on he opic so a . Sec ion 3 ou lines he heo e ical unde pinnings 3 Bank o In e na ional Se lemen s (2016) s a es ha he public deb - o-GDP a io inc eased in de eloped economies by mo e han 50 pe cen . Volume 18, Issue 3, 2018 197 o he empi ical amewo k applied and desc ibes he da a employed. Sec ion 4 discuss- es empi ical esul s, and Sec ion 5 concludes and desc ibes some o he ou s anding challenges. Li e a u e e iew Mone a y policy and inancial s abili y A ie ce deba e on he in e ac ion be ween economic policy and inancial s abili y e up ed a e he mos ecen inancial and economic c isis in 2007-2008 and o his poin , a numbe o bo h heo e ical and empi ical s udies we e published. A en ion was p ima ily gi en o he in e play o mone a y policy and asse p ices – a ela ionship ha u ned ou o be c ucial p io o he c isis. Ku ne (2013) p o ides an o e iew o he empi ical indings bo h p io o and a e he c isis. Cu en gene ally-accep ed heo y holds ha one may expec asse p ices o dec ease ollowing a con ac iona y mone a y policy shock h ough he unc ioning o an asse -p ice channel. Howe e , Galí and Gambe i (2015), using a ime- a ying amewo k, ind p o ac ed pe iods du ing which s ock p ices inc ease a e a mone a y igh ening. On he o he hand, Paul (2018) inds ha s ock p ices always dec ease ollowing con ac iona y mone a y policy shocks, while Aas ei e al. (2017) ind ha Fed episodically ook eal s ock p ice g ow h in o accoun . S ill, s ock p ice de elopmen s do no ha e a signi ican impac on mone a y policy decision-making due o hei highe ola ili y. In his a ea, housing p ices a e equen ly discussed, as hey a e conside ed an ea ly-wa ning indica o (G amlich e al., 2010, Babecky e al., 2013; Laina e al., 2015), and ended o inc ease sha ply be o e he c isis. The e o e, many au ho s ha e a gued o he inclusion o esiden ial eal es a e p ices in he consume p ice index and he mone a y policy decision-making p ocess (e.g Goodha 2001; Aydin and Volkan, 2011; Hampl and Ha anek, 2017). They a gue ha his could lead o smoo he business cycle luc ua ions compa ed o con en ional in la ion a ge ing. In his con ex , he e has been a enewed “lean o clean” deba e aimed a e i ying whe he he cen al bank should inco po a e asse p ice de elopmen in o i s decision- making p ocess, e en when he cu en in la iona y a ge is no a isk. Up un il he c isis, mone a y policy p ac i ione s only esponded o asse p ices i and when associ- a ed isks ac ually ma e ialized and we e ansmi ed in o he eal economy (“clean up a e wa ds” s a egy). E en oday, his app oach has i s ad oca es. S ensson (2016) p o ides a comp ehensi e discussion and e iew o exis ing empi ical s udies and con- cludes ha “leaning agains he wind” is s ill no ully jus i ied. Howe e , in ligh o ecen empi ical e idence showing ha loose mone a y policy in luences asse p ices, isk appe i e, and inancial s abili y in gene al, a g owing numbe o s udies a ou he leaning agains he wind s a egy (see Sme s, 2014, o a e iew). Those s udies claim ha mone a y policy should espond o inancial isk accumula ion o o es all hese isks’ ma e ializa ion and he associa ed nega i e impac on he eal economy (Fila do and Rungcha oenki kul, 2016). Following his in ense discussion, a consensus o so s eme ged in he o m o a mac o- p uden ial policy oolse o complemen exis ing capi al and liquidi y egula ions. In many coun ies, mac op uden ial policy ep esen s an au onomous b anch o economic policy wi h i s own objec i es ( inancial s abili y) and ools. This new pa adigm has Re iew o Economic Pe spec i es 198 gi en ise o a new se o ques ions ega ding he ex en o which mone a y policy is able o in luence inancial sec o de elopmen , as well as he ela i e posi ions o mone- a y and mac op uden ial policy, and hei espec i e a ge s. In heo y, he impac o mone a y policy on inancial s abili y is ela ed o mone a y policy ansmission channels: he asse -p ice channel, he bank-lending channel, and he balance-shee channel. Theo y sugges s ha lowe in e es a es should s eng hen i- nancial s abili y. Loose mone a y policy is, unde gene al ci cums ances, ansmi ed o lowe lending a es ( he bank-lending channel). Thus, loans become cheape and mo e a ac i e, which hen inc eases he olume o asse s, he sha e o loans on o al asse s, and banks’ p o i abili y. This also imp o es he balance shee s o economic subjec s ( he balance-shee channel). Ho man and Pee sman (2017) also speak o a new channel o mone a y policy ha wo ks h ough he deb se ice a io, de ined as o al deb pay- men s o he income o he p i a e non- inancial sec o . Ho man and Pee sman (2017) and Juselius e al. (2017) a gue ha mone a y expansion leads o a dec ease in he deb se ice a io, wi h lowe in e es a es on he s ock o deb ou weighing a ise in he deb - o-income a io. D ehmann and Juselius (2012) and Lomba di e al (2017) u he s a e ha changes in he deb se ice a io can ha e agg ega e mac oeconomic e ec s and signi ican ly in luence inancial s abili y. Also, one mus no o ge ha keeping in e es a es low in he long e m may induce households and i ms o g adually inc ease le e age h ough he con en ional in e - empo al subs i u ion e ec ( o mo e de ailed discussion see ESRB, 2016, and IMF, 2015). E en comme cial banks a e in luenced by he low in e es a e en i onmen , as o main ain hei p o i abili y, hey need o change hei po olio s uc u e in a ou o iskie asse s. Bo io and Zhu (2012) desc ibe his as he isk- aking channel o mone a y policy. Recen empi ical s udies ha e al eady shed some ligh on i s unc ioning (An- geloni e al., 2014; Abba e and Thale , 2015; Gilbe e al., 2018, o name a ew). Bo io (2014a) claims ha accumula ion o inancial disequilib ium occu s mos o en du ing posi i e supply shocks, which push down p ices while enhancing op imis ic expec a- ions and in es men in o iskie asse s. Se e al s udies s ess he need o some o m o policy coo dina ion be ween mone a y and mac op uden ial policy. The need o such coo dina ion s ems om he obse a ion ha mone a y and mac op uden ial policy ools a e no independen , as hey a ec bo h he mone a y and c edi condi ions ia hei e ec on c edi g ow h (Malo ana and F ai , 2017). A he same ime, he bes economic ou comes can be expec ed i bo h policies a e used in a complemen a y manne and a e execu ed by a single ins i u ion (Libich, 2017). Gala i and Moessne (2013) p o ide an o e iew o esea ch on mone a y- mac op uden ial policy in e ac ions. Fiscal policy and inancial s abili y Du ing he ecen inancial c isis, ex ao dina y measu es we e aken, no only by cen- al banks bu by go e nmen s as well, o p e en a collapse o he inancial sec o . Suppo packages om go e nmen s eached unp eceden ed le els and, despi e he ac hey migh endange iscal de ici s (Agnello and Sousa, 2009) and long- e m deb sus- ainabili y (Halle and Lewis, 2008; Schuknech e al., 2009), hey a e being jus i ied by he idea ha iscal policy migh be used o help economic eco e y and, i execu ed p ope ly, o os e inancial s abili y. In his spi i , BIS (2016) claims ha iscal policy Volume 18, Issue 3, 2018 199 should be, compa ed o he cu en s a e o a ai s, much mo e coun e cyclical. Fiscal policy should he e o e in imes o inancial boom gene a e a budge a y su plus and c ea e su icien iscal space o subsequen inancial cycle con ac ion. 4 Go e nmen s howe e o en use economic g ow h o inc ease manda o y expendi u es o go e nmen in es men s, which, despi e o e all posi i e economic de elopmen , lead o a nega i e p ima y balance. The e o e, iscal policy’s manoeu ing space may be subs an ially limi ed, especially due o ill-conside ed iscal policy s a egies du ing an economic boom. S ill, o his day he e is no uni ied iew on he linkages be ween iscal policy and asse p ices. This is due o he ac ha no all asse p ices eac alike o iscal policy shocks (Agnello and Sousa, 2013), and ha he iscal and inancial sec o a e inhe en ly in e linked, making i ha d o iden i y speci ic e ec s and hei di ec ion. To explain he in e linking in a mo e igo ous manne , le us conside he channels h ough which changes in so e eign isk may a ec banks. One such channel wo ks h ough he banks’ di ec holding o so e eign deb ( he asse holding channel). In gen- e al, a inancial boom o en suppo s so e eign c edi , which lowe s he isk o so e - eign de aul and imp o es banks’ po olios. Also, banks o en use so e eign secu i ies as colla e al o secu e wholesale unding om cen al banks, p i a e epo ma ke s, and issuance o co e ed bonds, and o back OTC de i a i e posi ions. So, when he p ice o so e eign bonds inc eases, he alue o he colla e al au oma ically inc eases as well ( he colla e al channel). A i (2016) shows ha du ing a c isis, banks become hea ily exposed o domes ic so e eign bonds, which may lead o a ise in bank unding cos s and he c owding ou o bank lending o he p i a e sec o . Dee and Hodula (2016) add ha in cases whe e go e nmen -owned banks di ec ly pa icipa e in la ge go e nmen al p ojec s, banking agili y may esul in he de e io a ion o s a e unds while also ais- ing he isk o so e eign de aul . Also, one mus no o ge ha so e eign a ings o en ep esen a ceiling o he a ing o domes ic inancial ins i u ions, and hus any upg ade in a coun y’s a ing also a ec s local banks ( he a ings channel). These channels, when wo king in he posi i e di ec ion du ing a inancial boom, may g ea ly imp o e banks’ balance shee s and he a ailabili y o addi ional capi al unding. Du ing a inancial cycle con ac ion, howe e , go e nmen deb usually g ows because o a dec ease in economic ac i i y and asse p ices. Acco ding o Bo io e al. (2015), economic ou pu is nega i ely in luenced o many yea s a e a c isis. 5 Du ing a inan- cial c isis, asse p ices signi ican ly dec ease and a ec consump ion and he eby indi- ec axes ia weal h e ec s. The g ow h o non-pe o ming loans and decline in asse p ices can also unde mine he heal h o p i a e inancial ins i u ions. In such cases, he go e nmen may be o ced o ecapi alize such ins i u ions om public unds (bail-ou cos s). 6 The e a e also likely o be second- ound e ec s on iscal a iables, pa icula ly 4 See e.g. BIS pape s: Bo io and Lowe (2002), D ehmann e al. (2012), Bo io (2014b). 5 They s a e ha du ing boom pe iods, ac o s o p oduc ion a e being mo ed o less p oduc i e and mo e p ocyclical sec o s (e.g. cons uc ion). This ine i ably deepens and p olongs he eco- nomic slowdown du ing inancial s ess and also weakens he sus ainabili y o public deb . 6 Fo he a e occasions when p oblems in he inancial sec o each his scope, a inancial c isis esolu ion mechanism was o med (acco ding o he Bank Reco e y and Resolu ion Di ec i e – BRRD). Thei aim is o p e en he need o bank ecapi aliza ion om public unds and he e o e o p e en a inancial c isis ha ing a one- ime nega i e impac on iscal sus ainabili y. Re iew o Economic Pe spec i es 200 when signi ican inancial ins abili y eeds back in o he economy ( o a mo e de ailed desc ip ion o ansmission channels, see Eschenbach and Schuknech , 2004). Fiscal-mone a y- inancial s abili y in e ac ions O e all, he exis ing esea ch on iscal- and mone a y- inancial s abili y in e ac ions may be g ouped in o wo s ands. One s and analyzes he e ec s o mone a y and iscal policies on he eal economy and he inancial sec o sepa a ely, and abs ac s om he in e linkages be ween indi idual economic policy measu es. A e iew o such s udies, al hough by no means exhaus i e, was p esen ed in he p e ious sub-sec ions. The sec- ond, e e -expanding s and o li e a u e analyzes he beha iou o economic agen s in e ms o in e ac ion and exchange o in o ma ion. O e ime, i became c ucial o ac- coun o he ac ha bo h mone a y and iscal policy in luence one ano he and in e ac wi h hei b oad se o ins umen s. This in e ac ion and he (in)compa ibili y o hei measu es gi e ise o a ious impac s on he eal economy and inancial sec o . I is easonable o expec ha none o he ins i u ions in ol ed will comple ely igno e he beha iou o o he economic policy agen s. The heo e ical ounda ions o iscal and mone a y policy in e ac ions a e well es ablished in he li e a u e (Sa gen and Wallance, 1981; Leepe , 1991; Wood o d, 1996, among o he s). Empi ical a emp s o analyze policy in e ac ions may be ound e.g. in Musca elli e al.(2004), Moun o d and Uhlig (2009), Rossi and Zubai y (2011) and ecen ly in Bianchi and Ilu (2017) and O - phanides (2017). These s udies adop di e en app oaches o he analysis, bu he au- ho s gene ally ag ee ha mone a y and iscal policies do no con adic hemsel es in he e en o shocks o ou pu (supply o demand shocks) and can ac as subs i u es in he case o in la ion shocks o shocks a ec ing indi idual economic policy ins umen s. We con ibu e o his li e a u e by p o iding comp ehensi e ime se ies e idence on iscal- mone a y- inancial s abili y in e ac ions. We do so in a lexible amewo k using in o - ma ion om hund eds o mac oeconomic ime se ies, which signi ican ly lowe s he in o ma ion bias. We ely mainly on Czech mac oeconomic da a, bu ou modelling amewo k can be ex ended o o he economies. The heo e ical ounda ions o policy and inancial s abili y in e ac ions can be ound in Wood o d (2011) and Ca ls om e al. (2010). Ueda and Valencia (2014) build a model based on a loss unc ion wi h h ee elemen s: a ia ions o ou pu , in la ion, and p i a e sec o le e age. They de i e he ollowing, a he in ui i e equa ion:       1 ln ee yy             : , (1) which shows ha ex-pos le e age in he economy is gi en by su p ises in in la ion   e   , ou pu   e yy , and c edi g ow h  . C edi g ow h is in u n de e - mined by egula o y measu es and c edi shocks. The ela ionship desc ibed in (1) sug- ges s ha he inc ease o de ia ion om equilib ium o in la ion   e   and ou pu   e yy lowe s p i a e sec o le e age  . Assuming ha he inancial isk is posi- i ely co ela ed wi h he le el o le e age, eq. (1) sugges s ha loose economic policies lowe inancial isks in he economy and he e o e he isk o inancial ins abili y in he u u e. In his pape , we a gue ha he unc ioning o he economy migh no be as s aigh o wa d as he heo e ical models sugges , as he e ec could go ei he way, i.e., may be posi i e o nega i e, and is signi ican ly ime-dependen . Volume 18, Issue 3, 2018 201 Empi ical me hodology To s udy he iscal-mone a y- inancial s abili y in e ac ions, we use he ac o - augmen ed ec o au o eg ession model (FAVAR) in oduced in Be nanke e al. (2005). Ou p ima y mo i a ion o choosing he FAVAR model is o a oid he in o ma ion bias when iden i ying he se o economic policy inno a ions. 7 Also, we wan o use he ad an ageous logic o VAR models, which a e a heo y– ee way o “le he da a speak” abou causali y ques ions. Las , one can ind many ypes o au o eg essi e pa e ns in mac oeconomic and inancial ime se ies, implying ha he eal economy does no con- s i u e a andom en i y. A VAR model accoun s o hese pa e ns and, o each a iable en e ing he model, compu es an equa ion explaining he a iable’s e olu ion based on i s own and o he a iables’ lagged alues. In con as o a simple VAR model, he FAVAR model includes unobse ed low- dimensional ac o s in he au o eg ession, educing he in o ma ion bias. The FAVAR model hus u ilizes he ad an ages o a da a ich en i onmen , while emaining ac able in e ms o he numbe o pa ame e s o be es ima ed. We speci y an 1M ec o o mac oeconomic ime se ies Y and a 1K ec o o unobse ed ac o s F . We as- sume ha he join dynamics o F , Y is gi en by he ollowing equa ion:   1 1 . FF L YY                   , (2) whe e   L is a lag polynomial and  is an e o e m wi h ze o mean and co a i- ance ma ix Q. Equa ion (2) is a s anda d VAR model ha can be in e p e ed as a e- duced o m o a linea a ional-expec a ions model wi h bo h obse ed and unobse ed a iables. The unobse ed a iables make he model impossible o es ima e; he e o e, we assume ha he addi ional in o ma ional ime se ies X a e linked o he unobse - able ac o s F and he obse able ac o s Y by: y X F Y e         , (3) whe e  and y  a e ma ices o ac o loadings and e is a se ially unco ela ed e o e m wi h a ze o mean (inno a ion shock). Equa ion (3) cap u es he idea ha bo h ec o s Y and F a e pe asi e o ces ha migh d i e he common dynamics o X . This s a ic ep esen a ion o he dynamic ac o model enables us o es ima e he ac o s by p incipal componen s. As he s a ic ac o s inco po a e in o ma ion om a la ge numbe o economic a iables, he in o ma ion se o he s uc u al ac o model is a g ea e han ha o a s anda d VAR. Thus, i becomes unlikely ha he in o ma ion se 7 A si ua ion in which he econome ician's in o ma ion se is smalle han ha o he economic agen s. I his is he case, he ela i ely small numbe o a iables in a small model may no be su icien o p ope ly iden i y shocks, which inc eases he isk o a biased es ima e. Fo example, when ying o iden i y a mone a y policy shock in a VAR model, he shock may ac ually no be uly exogenous, as i may also cap u e ins ances when he cen al bank endogenously eac s o changing in la ion expec a ions. Fo ni and Gambe i (2010) demons a e ha non- undamen als can accoun o he well-known VAR p ice puzzle and he delayed o e shoo ing puzzle. Simila - ly, Iwa a (2013) discusses wo iscal policy puzzles and hei possible explana ions. Re iew o Economic Pe spec i es 202 o economic agen s will be supe io o he in o ma ion se employed by us. In ou appli- ca ion, he we assume ha he ec o o obse able a iables Y holds only ou speci- ied inno a ions, which a e hen assumed o ha e pe asi e e ec on he en i e econo- my. No e ha any emaining ime se ies om ou as da ase may be linked o he ac o s ou side o he VAR model ia ac o loadings iden i ied by he p incipal compo- nen analysis. Fo de ails on he es ima ion p ocedu e, please consul he Appendix C. 8 Da a and iden i ica ion scheme Ou ec o X o ac o ex ac ion consis s o a balanced panel o 140 qua e ly ime se ies ep esen ing he Czech economy and he es o he wo ld. They a e d awn mainly om he Czech Na ional Bank, Czech S a is ical O ice, and ECB da abases. The da a spans he pe iod 2001:Q1 – 2016:Q1. Gene ally, i is no equi ed o pe o m any ex an e ca ego iza ion o da a, bu we can bene i om s acking da a in o sub-g oups in acco dance wi h he di e en classes o economic a iables o he sake o he cla i y o ou compu a ional p ocess. The da a sub-g oups and co esponding a iable coun s a e p esen ed in Table 1 below. No e ha p io o es ima ion, he da a was ans o med o assu e s a iona i y o he ime se ies using na u al loga i hms and i s di e ences. By modelling he iscal-mone a y- inancial s abili y in e ac ions in a da a ich en i onmen , we con ol o eal economy de elopmen , changes in iscal and mone a y policy, inan- cial sec o de elopmen , and ex e nal in luences. We iden i y policy inno a ions using ecu si e o de ing, placing unobse ed ac o s be o e obse ed ac o s. The p incipal assump ion is ha unobse ed ac o s do no espond o policy inno a ions wi hin he i s qua e . In o de o iden i y policy inno a- ions, we di ide ou panel o a iables in o wo g oups: slow- and as -mo ing a iables. Blocks desc ibing he ex e nal en i onmen , eal economy, iscal a iables, and p ices a e classed as slow-mo ing (in he o de gi en in Table 1). A slow-mo ing a iable is one ha is la gely p ede e mined in he cu en pe iod and is assumed no o espond ins an aneously o he speci ied shocks. The es o he blocks a e classed as as - mo ing a iables, which a e assumed o be highly sensi i e o con empo aneous eco- nomic news o shocks. In case o a iscal shock, all iscal a iables a e classed as as - mo ing as in Lagana and Sg o (2011). No e ha he a iables om which we ex ac he inno a ions a e always o de ed las in he co a iance ma ix (and ea ed as a ac o on hei own). This means ha we assume each o he gi en inno a ions o a ec ou la en ac o s wi h a lag o one qua e . Since we wan o a oid a sho age o deg ees o ee- dom, we p e e o use a smalle model wi h lowe numbe o lags. The s anda d in o - ma ion c i e ia es s sugges h ee lags, bu using mo e sensi i e exclusion-based Gen- e al- o-Speci ic app oach, we ind ha wo lags a e su icien . The e o e, ou baseline FAVAR model con ains wo lags. Ne e heless, we check o he obus ness o ou esul s la e . 8 The FAVAR modelling amewo k is used in many economic applica ions, see o ins ance Fo ni and Gambe i (2010), Eickmeie and Ho mann (2013), Aas ei (2013) o Hodula and P ei - e (2018). Volume 18, Issue 3, 2018 203 Table 1 Sub-g oups in he da ase Da a Sub-G oups Slow/Fas Mo ing Numbe o Va iables Ex e nal en i onmen (S) 12 Real economy (S) 32 Labou ma ke (S) 17 Go e nmen (S) 12 P ices and p ice expec a ions (S) 20 In e es a es and c edi (F) 29 Financial sec o (F) 12 Exchange a es (F) 6 No e: The Appendix lis s he ime se ies included in hese sub-g oups. Sub-g oups highligh ed in bold con ain a iables used as he sou ce o an iden i ied shock. Such a iables a e ne e includ- ed in he da ase om which we ex ac he ac o s. We conside h ee ypes o economic policy shocks: mone a y and iscal policy expan- sion and sys emic isk ma e ializa ion. The main policy ool o he CNB is a wo-week epo a e. Howe e , because he epo a e does no change con inuously bu only as an ou come o CNB Boa d o Go e no s mee ings, we use he in e -bank a e o p oxy o he CNB’s key mone a y policy a e; simila o how i is done in he CNB’s own o e- cas ing sys em. Hence, we iden i y an expansiona y mone a y policy shock as a de- c ease in PRIBOR 3M. F om he inancial s abili y s andpoin , an in e es a e d op inc eases he economy’s le e age and boos s he isk appe i e o economic subjec s, and he e o e may h ea en inancial s abili y. The main iscal policy a iables a e go e n- men e enue om axes and o al go e nmen expendi u e, ei he o which may be used as a sou ce o he inno a ions. Howe e , using go e nmen e enue om axes as a sou ce a iable inc eases he isk o endogenei y, since go e nmen e enue g ow h is associa ed wi h business cycle expansion. On he basis o hese sho comings, we iden i- y an expansiona y iscal policy shock as an inc ease in o al go e nmen expendi u e. 9 Las bu no leas , we conside he impac o sys emic isk ma e ializa ion as pa o inancial cycle de elopmen . We d aw his in o ma ion om he non-pe o ming loans (NPL) a io ime se ies. Du ing inancial s ess, he NPL a io g ows because o an inc ease in he absolu e le el o non-pe o ming loans and a dec ease in newly-g an ed loans. Hence, he sys emic isk ma e ializa ion shock is iden i ied as an inc ease in he NPL a io. We conduc a numbe o checks o e i y he obus ness o ou esul s. Fi s , we use al e na i e a iables and ime ames du ing he iden i ica ion o shocks. In case o mone a y policy expansion, we check he obus ness o esul s wi h espec o he CNB’s exchange a e commi men , which s a ed in No embe 2013, and he model wi h da a ending in 2012Q1. 10 By cu ing he sample, we also add ess he ac ha he 9 Addi ionally, while changes in asse p ices may in luence go e nmen e enues, hey a e much less likely o a ec go e nmen spending. 10 Fo mo e de ails on he exchange a e commi men (and ecen exi ) please consul he CNB websi e a h ps://www.cnb.cz/en/mone a y_policy/exi _exchange_ a e_commi /index.h ml Re iew o Economic Pe spec i es 210 Figu e 4 Sys emic isk ma e ializa ion, policy esponses and he inancial sec o No es: Median impulse esponses a e epo ed wi h 90% p obabili y bands. The y-axis measu es he s eng h o he a iable’s esponse in pe cen age poin s; he x-axis is in qua e s a e he shock. All a iables en e he model as annualized pe cen age g ow h. Figu e 4 gi es indica ions as o he causes behind he sys emic isk ma e ializa ion in he inancial sec o : Wi h he dec eased abili y o economic agen s o epay hei loans, we documen a a he sha p decline in bo h c edi dynamics and housing p ices. This ad e se ma ke si ua ion a ec s mainly comme cial banks, which collec i ely become much mo e isk-a e se, changing hei po olios in a o o less isky asse s (in p ac ice, his would mani es as inc eased exposu e o he go e nmen and cen al bank). This is a simple signaling s a egy whe ein banks s i e o p esen hemsel es as s able o de- c ease he cos o addi ional capi al, which, due o he c isis, gene ally inc eases. In spi e o dec easing isk-weigh ed asse s (ou come o he abo e-men ioned po olio cleans- ing), capi al su plus signi ican ly dec eases. This migh also be achie ed by simply inc easing he capi al equi emen s. Ma e ializa ion o sys emic isk inc eases loss p o- isions and isk cos s, which ep esen a signi ican componen o he in e es a e on loans. G ow h o in e es a es on loans o he p i a e sec o inc eases he deb se ice a io and migh lead o u he de e io a ion o he loan po olio. Conclusions We explo e si ua ions in which iscal, mone a y, and inancial s abili y may in e ac , and con ibu e o he discussion abou he ela ed policies’ coo dina ion and po en ial -0,8 -0,6 -0,4 -0,2 0,0 0,2 0,4 0 5 10 15 Housing p ice index -0,8 -0,6 -0,4 -0,2 0,0 0,2 0,4 0 5 10 15 Loans o p i a e sec o -0,4 -0,2 0,0 0,2 0 5 10 15 Risk-weigh ed asse s -0,4 -0,2 0,0 0,2 0,4 0,6 0 5 10 15 Deb se ice a io -0,4 -0,2 0,0 0,2 0,4 0,6 0,8 1,0 1,2 0 5 10 15 Loss p o isions -0,3 -0,2 -0,1 0,0 0,1 0,2 0,3 0 5 10 15 Capi al su plus NPL a io inc ease Volume 18, Issue 3, 2018 211 con lic s. We highligh he need o ake in o conside a ion bo h iscal and mone a y policy, as hey may bo h a ec asse p ices and c edi dynamics and con ibu e o sys- emic isk accumula ion and he e o e in luence inancial cycle ampli ude. Fo his pu pose, we cons uc a FAVAR model o cap u e he policy in e play in a da a- ich en i onmen . The FAVAR model helps ensu e ha he es ima ed impulse esponses a e in a ian wi h espec o ex ensions o he in o ma ion se – an issue ha o en plagues impulse esponse esul s. The p esen ed model enables us o iden i y se e al pa e ns. Fi s , loose economic poli- cies ha e a posi i e impac on inancial s abili y in he sho e m, bu his e ec may e e se in he medium e m. In g ea e de ail, we ind ha iscal and mone a y policy- like shocks impac he economy and inancial sec o di e en ly. While iscal expansion in luences c edi dynamics and he ela ed se o inancial sec o a iables in he sho e m and hen quickly ades ou , mone a y expansion seems o bene i inancial s abili y a i s , bu i s e ec s u n nega i e in he medium e m. This somewha complica es he answe s o he i s wo esea ch ques ions p esen ed in he in oduc ion: Fo he i s ques ion, loose economic policies migh indeed bene i inancial s abili y in he sho e m, bu (i kep accommoda i e long enough) hey will e en ually wo k in he oppo- si e di ec ion, owa ds ins abili y. Fo he second, yes, iscal and mone a y policy shocks impac he inancial sec o di e en ly. We highligh he need o conside he ull policy mix ( iscal and mone a y policy e ec s) when o mula ing app op ia e policy measu es. Rega ding ou hi d esea ch ques ion, we ind ha inancial imbalances (sys emic isk ma e ializa ion) cause losses in ou pu , damage public inances, and igge de la iona y p essu es. Fu he mo e, sys emic isk ma e ializa ion leads o inc eases in he deb se - ice a io and migh lead o u he de e io a ion o he loan po olio. O e all, ou esul s con i m he need o discuss and coo dina e changes in economic policy o a oid po en ial con lic si ua ions and su p ises in he ma ke . Going beyond exis ing esea ch, we also p o ide ime-se ies e idence showing ha mac op uden ial policy canno iew iscal policy as Rica dian (passi e), bu mus conside i simila ly o how i iews mone a y policy. Fu he , ou inding ha bo h iscal and mone a y policy may be ansmi ed in o he inancial sec o and in luence he isk- aking beha io o economic agen s p o ides suppo o coun e cyclical iscal and mone a y policy. The e o e, we make se e al policy ecommenda ions ha may dec ease he p ocyclical cha ac e o economic policy and mi iga e possible con lic si ua ions a low implemen- a ion cos : In he iscal policy a ea, we belie e implemen ing a iscal ule o es ic he p ocyclical cha ac e o public inances and s abilize go e nmen deb o e he long e m would be bene icial. Howe e , as he Bank o In e na ional Se lemen s (2016) s a es, i is im- po an o augmen he iscal ule wi h a p ope au oma ic s abiliza ion scheme, and apply i ex an e when ce ain economic condi ions a e me . Fu he , Bo io e al. (2013) ecommend including in o ma ion abou inancial cycle de elopmen in o he po en ial p oduc and ou pu gap es ima ion. Ano he possibili y o mi iga ing he unwan ed iscal policy p ocyclicali y associa ed wi h sys emic isk build-up would be o pa ially adjus he axa ion sys em in o de o limi he g ow h o ce ain ypes o c edi . Gi en he p ocyclical de elopmen o esiden ial p ope y p ices and loans o he p i a e sec o , Re iew o Economic Pe spec i es 212 i would be bene icial o limi mo gage ax elie (see And ews e al., 2011). 13 The Eu opean Commission (2015) has encou aged Membe S a es o ensu e ha ax sys ems do no encou age household deb . Lomba di e al. (2017) gi e e idence o he nega i e impac o high household indeb edness on GDP g ow h o e he long e m. The e a e possibili ies o limi he impac o so e eign isk on he banking sec o . The Czech Na- ional Bank was among he i s o implemen me hods o public inance s ess es ing wi h special capi al equi emen s on banks wi h highe so e eign de aul isk on go - e nmen bonds (CNB, 2016). The impac o mone a y policy ac ions on inancial s abili y may be pa ially mi iga ed by inco po a ing esiden ial p ope y p ices in he a ge ed consume p ice index o by using a b oade index (Hampl and Ha anek, 2017, desc ibe CPIH on he case o he Czech Republic) as a supplemen a y indica o o mone a y policy decisions. The e a e also o he , mo e con o e sial p oposi ions o mi iga ing he p ocyclical cha ac e o mone a y policy. Bo io (2016) sugges s he use o an augmen ed Taylo ule, in which he mone a y au ho i y should espond no only o he in la ion gap bu also o some de ined inancial s abili y gap, and s a e ha a mone a y policy ule ha akes inancial de elopmen s in o accoun could help educe he inancial cycle, leading o highe ou - pu in he long un. Acknowledgemen s: We would like o hank Ja omi Baxa, Ales Melecky and wo anonymous e e ees o hei help ul commen s on ea lie e sions o his pape . We would also like o hank he semina pa icipan s a he 2016 Con e ence on Cu ency, Banking, and In e na ional Finance, he 2016 Eu opean Financial Sys ems Con e ence, Technical Uni e si y o Os a a, and he Slo ak Academy o Sciences o hei com- men s. The iews and opinions exp essed he ein a e hose o he au ho s and do no ep esen he iews o hei ins i u ions. All e o s and omissions emain en i ely he aul o he au ho s. Funding: This wo k was suppo ed by he 2017 esea ch g an (SP2017/110) om Technical Uni e si y o Os a a and he Czech Science Agency, g an An i-cyclical policies and ex e nal equilib ium in a model o in la ion a ge ing, No. 18-12340S. Disclosu e s a emen : No po en ial con lic o in e es was epo ed by he au ho s. Re e ences AASTVEIT, K. A. (2013). Oil p ice shocks and mone a y policy in a da a- ich en i onmen . 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Da a desc ip ion and sou ces G oup No. Se ies desc ip ion Uni Sou ce TC S/F Real economy 1 Indus ial p oduc ion index, indus y o al 2010=100 CSO -Indus y, ene gy 2* S 2 Indus ial p oduc ion index, mining and qua ying 2010=100 CSO -Indus y, ene gy 2* S 3 Indus ial p oduc ion index, manu ac u ing 2010=100 CSO -Indus y, ene gy 2* S 4 Indus ial p oduc ion index, elec ici y, gas, s eam and ai condi ioning 2010=100 CSO -Indus y, ene gy 2* S 5 Sales om indus ial ac i i y, indus y o al 2010=100 CSO -Indus y, ene gy 2* S 6 Sales om indus ial ac i i y, mining and qua ying 2010=100 CSO -Indus y, ene gy 2* S 7 Sales om indus ial ac i i y, manu ac u ing 2010=100 CSO -Indus y, ene gy 2* S 8 Sales om indus ial ac i i y, elec ici y, gas, s eam and ai condi ioning 2010=100 CSO -Indus y, ene gy 2* S 9 Di ec expo sales, indus y o al 2010=100 CSO -Indus y, ene gy 2* S 10 Di ec expo sales, mining and qua ying 2010=100 CSO -Indus y, ene gy 2* S 11 Di ec expo sales, manu ac u ing 2010=100 CSO -Indus y, ene gy 2* S 12 Domes ic sales, indus y o al 2010=100 CSO -Indus y, ene gy 2* S 13 Domes ic sales, mining and qua ying 2010=100 CSO -Indus y, ene gy 2* S 14 Domes ic sales, manu ac u ing 2010=100 CSO -Indus y, ene gy 2* S 15 Domes ic sales, elec ici y, gas, s eam and ai condi ioning supply 2010=100 CSO -Indus y, ene gy 2* S 16 New indus ial o de s, indus y o al 2010=100 CSO -Indus y, ene gy 2* S 17 Non-domes ic new o de s 2010=100 CSO -Indus y, ene gy 2* S 18 Domes ic new o de s 2010=100 CSO -Indus y, ene gy 2* S 19 Cons uc ion p oduc ion index 2010=100 CSO - Cons uc ion 2* S 20 House p ice index, buildings 2010=100 CSO - Cons uc ion 2* S 21 House p ice index, ci il enginee ing wo ks 2010=100 CSO - Cons uc ion 2* S 22 Re ail ade eceip s 2010=100 CNB, ARAD 2* S 23 G oss domes ic p oduc , ma ke p ices Millions CZK CSO - GDP 2* S 24 GDP de la o 2010=100 CNB, ARAD 2* S 25 Final consump ion expendi u es, o al, cu en p ices Millions CZK CSO - GDP 2* S 26 Final consump ion expendi u es, households, cu en p ices Millions CZK CSO - GDP 2* S 27 Final consump ion expendi u es, go e nmen , cu en p ices Millions CZK CSO - GDP 2* S 28 Final consump ion expendi u es, non-p o i o ganisa ions, cu en p ices Millions CZK CSO - GDP 2* S 29 G oss capi al o ma ion, o al, cu en p ices Millions CZK CSO - GDP 2* S 30 Expo , cu en p ices Millions CZK CSO - GDP 2* S 31 Impo , cu en p ices Millions CZK CSO - GDP 2* S 32 Real g oss domes ic income Millions CZK CSO - GDP 2* S 33 Deb se ice a ios o he p i a e non- inancial sec o % BIS da abase 2 S Labou ma ke 34 Indus y o al, a e age numbe o pe sons employed (ANPE) no. o pe sons CSO -Indus y, ene gy 2* S 35 Indus y, mining and qua ying, ANPE no. o pe sons CSO -Indus y, ene gy 2* S 36 Indus y, manu ac u ing, ANPE no. o pe sons CSO -Indus y, ene gy 2* S 37 Indus y, elec ici y, gas, s eam and ai condi ioning supply, ANPE no. o pe sons CSO -Indus y, ene gy 2* S 38 Indus y o al, a e age g oss nominal wage (AGNW) CZK pe pe son CSO -Indus y, ene gy 2* S 39 Indus y, mining and qua ying, AGNW CZK pe pe son CSO -Indus y, ene gy 2* S 40 Indus y, manu ac u ing, AGNW CZK pe pe son CSO -Indus y, ene gy 2* S 41 Indus y, elec ici y, gas, s eam and ai condi ioning supply, AAGNWNPE CZK pe pe son CSO -Indus y, ene gy 2* S 42 Cons uc ion o al, a e age numbe o pe sons employed (ANPE) no. o pe sons CSO - Cons uc ion 2* S 43 Cons uc ion o al, a e age g oss nominal wage (AGNW) CZK pe pe son CSO - Cons uc ion 2* S 44 Employees o al, hou s wo ked housand hou s CSO - GDP 2* S 45 Employees, Ag icul u e, o es y and ishing housand hou s CSO - GDP 2* S 46 Employees, Manu ac u ing, mining and qua ying and o he indus y housand hou s CSO - GDP 2* S 47 Employees, Cons uc ion housand hou s CSO - GDP 2* S 48 Employees, T ade, anspo a ion, accommoda ion and ood se ice housand hou s CSO - GDP 2* S 49 Employees, Public adminis a ion, educa ion, heal h and social wo k housand hou s CSO - GDP 2* S 50 Gene al unemploymen a e o he aged 15 o 64 yea s % CNB, ARAD 1* S Volume 18, Issue 3, 2018 219 51 Job Vacancies housand CNB, ARAD 2* S 52 Unplaced job seeke s housand CNB, ARAD 2* S Go e nmen 53 Go e nmen deb , o al Millions CZK CSO - Go e nmen 2* S 54 Deb secu i ies, o al Millions CZK CSO - Go e nmen 2* S 55 Deb secu i ies, sho - e m Millions CZK CSO - Go e nmen 2* S 56 Deb secu i ies, long- e m Millions CZK CSO - Go e nmen 2* S 57 Go e nmen loans, o al Millions CZK CSO - Go e nmen 2* S 58 Go e nmen loans, sho - e m Millions CZK CSO - Go e nmen 2* S 59 Go e nmen loans, long- e m Millions CZK CSO - Go e nmen 2* S 60 Deb in e es s payed Millions CZK CSO - Go e nmen 2* S 61 Go e nmen expendi u es, o al Millions CZK CSO - Go e nmen 2* S 62 Go e nmen e enue, o al Millions CZK CSO - Go e nmen 2* S P ices and p ice expec a ions 63 Consume P ice Index (CPI), o al 2015 = 100 CNB, ARAD 2* S 64 CPI, ood and non-alcoholic be e ages 2015 = 100 CSO - P ices 2* S 65 CPI, alcoholic be e ages, obacco 2015 = 100 CSO - P ices 2* S 66 CPI, clo hing and oo wea 2015 = 100 CSO - P ices 2* S 67 CPI, housing, wa e , elec ici y, gas and o he uels 2015 = 100 CSO - P ices 2* S 68 CPI, u nishings, household equipmen , ou ine main enance 2015 = 100 CSO - P ices 2* S 69 CPI, heal h 2015 = 100 CSO - P ices 2* S 70 CPI, anspo 2015 = 100 CSO - P ices 2* S 71 CPI, communica ions 2015 = 100 CSO - P ices 2* S 72 CPI, ec ea ion and cul u e 2015 = 100 CSO - P ices 2* S 73 CPI, educa ion 2015 = 100 CSO - P ices 2* S 74 CPI, es au an s and ho els 2015 = 100 CSO - P ices 2* S 75 CPI, miscellaneous goods and se ices 2015 = 100 CSO - P ices 2* S 76 Indus ial P oduce P ices (IPP), o al 2015 = 100 CSO - P ices 2* S 77 IPP, mining and qua ying 2015 = 100 CSO - P ices 2* S 78 IPP, manu ac u ing 2015 = 100 CSO - P ices 2* S 79 IPP, elec ici y, gas, s eam and ai condi ioning supply 2015 = 100 CSO - P ices 2* S 80 IPP, wa e supply; sewe age, was e managemen and emedia ion 2015 = 100 CSO - P ices 2* S 81 Ma ke se ices p ice indices in he business sphe e, o al 2015 = 100 CSO - P ices 2* S 82 In la ion expec a ions o non- inancial co po a ions and companies % CNB, ARAD 1 F 83 Financial ma ke in la ion expec a ions % CNB, ARAD 1 F In e es a es and c edi s 84 Repo a e - 2 weeks % CNB, ARAD 1 F 85 PRIBOR 3M % CNB, ARAD 1 F 86 PRIBOR 1Y % CNB, ARAD 1 F 87 Go e nmen bond yield 2Y % CNB, ARAD 1 F 88 Go e nmen bond yield 5Y % CNB, ARAD 1 F 89 Go e nmen bond yield 10Y % CNB, ARAD 1 F 90 Bank in e es a es on CZK-denomina ed loans, households o al % CNB, ARAD 1 F 91 Bank in e es a es on CZK-denomina ed loans, households, up o 1Y % CNB, ARAD 1 F 92 Bank in e es a es on CZK-denomina ed loans, households, up o 5Y % CNB, ARAD 1 F 93 Bank in e es a es on CZK-denomina ed loans, households, o e 5Y % CNB, ARAD 1 F 94 Bank in e es a es on CZK-denomina ed loans, households consume c edi - o al % CNB, ARAD 1 F 95 Bank in e es a es on CZK-denomina ed loans, households o house pu chase - o al % CNB, ARAD 1 F 96 Bank in e es a es on CZK-denomina ed loans, households o he loans - o al % CNB, ARAD 1 F 97 Bank in e es a es on CZK-denomina ed loans, non- inancial co po a ions % CNB, ARAD 1 F 98 Bank in e es a es on CZK-denomina ed loans, non- inancial co po a ions, up o 1Y % CNB, ARAD 1 F 99 Bank in e es a es on CZK-denomina ed loans, non- inancial co po a ions, up o 5Y % CNB, ARAD 1 F 100 Bank in e es a es on CZK-denomina ed loans, non- inancial co po a ions, o e 5Y % CNB, ARAD 1 F 101 Mone a y base, mon hly a e age Billions CZK CNB, ARAD 2 F 102 Mone a y agg ega e M1 Millions CZK CNB, ARAD 2 F 103 Mone a y agg ega e M2 Millions CZK CNB, ARAD 2 F 104 Loans o esiden s and non- esiden s - MFIs Millions CZK CNB, ARAD 2 F