Working Paper: CEPR ID: DP17777
Authors: Tobias Adrian; Fernando Duarte; Tara Iyer
Abstract: We propose the log conditional volatility of GDP spanned by financial factors as "Volatility Financial Conditions Index" (VFCI) and derive conditions under which it is the log market price of risk. The VFCI exhibits superior explanatory power for stock and bond risk premia compared to other FCIs. We use a variety of identification strategies and instruments to demonstrate robust causal relationships between the VFCI and macroeconomic aggregates: a tightening of the VFCI leads to a persistent contraction of output and triggers an immediate easing of monetary policy. Conversely, contractionary monetary policy shocks cause tighter financial conditions.
Keywords: macrof finance; monetary policy; financial conditions; growth-at-risk; market price of risk; consumption volatility
JEL Codes: E44; E52; G12
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| VFCI tightening (G24) | output contraction (E32) |
| VFCI tightening (G24) | monetary policy easing (E52) |
| contractionary monetary policy shocks (E39) | VFCI tightening (G24) |