Using FAVAR Model to Test the Credit Channel Monetary Policy Transmission Mechanism in Long-term Credit Cycle

University essay from Handelshögskolan i Stockholm/Institutionen för finansiell ekonomi

Abstract: In this paper, based on the FAVAR model created by Ben Bernanke, 115 groups of economic variables' data from January 1959 to December 2014 were selected for the empirical analysis. From January 1959 to August 2008, the fed funds rate was used to work as the indicator of the monetary policy. From September 2008 to December 2014, since the fed funds rate was kept unchanged at the zero lower bound, the Wu-Xia shadow fed funds rate was used to substitute for the fed funds rate so as to let the indicator of the monetary policy to be changeable again. Based on the comparison of the impulse response results, we can conclude that compare with the traditional VAR model, the FAVAR model is a more efficient and stable model. And the FAVAR model is very useful in providing the guidance when the fed is deciding the monetary policy. By including more variables into the FAVAR with the help of the two-step principal components analysis method, the FAVAR can include the information about the frictions of the credit market and the existence of the information asymmetry in the financial market. When it comes to the enterprise balance sheet channel indicators, the traditional VAR model can prove the existence of the extra costs in the external financing. Since the financing costs related to the inventory investment are the opportunity costs of the company's internal funds and the financing costs related to the non-residential construction investment are the costs in the external financing, they would react differently to the monetary policy shocks because of the differences in the related financing costs. But when it comes to the bank credit channel indicators, because of the lack of information, through the impulse response result, the traditional VAR model would give the indication that a tightening monetary policy shock would have a positive effect on the commercial loans, and we can conclude that this is totally wrong since it is not in accordance with the economic theory and the reality. However, the FAVAR model can solve this problem quite well and the negative effect of the monetary policy shock on the commercial loans can be presented through the impulse response function result. Based on the current macroeconomic situation of the United States and Bernanke's related theory of monetary policy transmission mechanism, we would discuss the problem of using the large scale asset purchase program as the main monetary policy tool and give our policy recommendation to the policy maker: the collaboration between the monetary policy and the fiscal policy should be considered in the next recession when the traditional interest rate tools and the quantitative easing tools are less effective.

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