Managing Macrofinancial Risk

IMF Working Papers, August 7, 2020

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Augments a linearized dynamic stochastic general equilibrium (DSGE) model with a tractable endogenous risk mechanism to support joint analysis of monetary and macroprudential policy.
Introduces a state dependent conditional heteroskedasticity mechanism that specifies the conditional variances of structural shocks as functions of the business or financial cycle.
The heteroskedastic linearized DSGE model:
- Preserves the satisfactory simulation and forecasting performance of its nested homoskedastic counterpart for the conditional means of endogenous variables.
- Substantially improves goodness of fit to the conditional distributions of endogenous variables.
- Matches the key stylized facts of growth at risk.

State dependent conditional heteroskedasticity materially affects the model’s representation of risk and tail outcomes:
- Conditional variances of structural shocks are explicit functions of the business or financial cycle.
- Improved fit to conditional distributions enables matching growth-at-risk stylized facts.
The heteroskedastic specification retains conditional mean forecasting performance while delivering superior distributional accuracy relative to the homoskedastic nested model.

Monetary policy:
- Accounting for state dependent conditional heteroskedasticity makes it optimal for monetary policy to respond more aggressively to the business cycle.
Macroprudential policy:
- Macroprudential policy should manage the resilience of the banking sector more actively over the financial cycle, given endogenous risk dynamics.
Joint policy analysis:
- The augmented model supports integrated evaluation of monetary and macroprudential policy trade-offs in environments where risk is endogenous and state dependent.

Subjects: Banking, Financial institutions, Financial sector policy and analysis, Financial services, Housing prices, Macroprudential policy, Mortgages, Prices, Production, Production growth, Short term interest rates
Keywords: bank credit, business cycle, capital stock, constant returns to scale, default rate relationship, default shock, Dynamic stochastic general equilibrium model, Endogenous risk, Financial cycle, gross domestic product, Growth at risk, Housing prices, loan rate, Macroprudential policy, marginal revenue, markup shock, math display, maximization problem, Monetary policy, Mortgages, output gap, price level, probability density function, Production growth, rate determination, risk premium, Short term interest rates, State dependent conditional heteroskedasticity, stochastic process, utility function, WP

Source: IMF Working Paper "Managing Macrofinancial Risk" by Tobias Adrian and Francis Vitek (Working Paper No. 2020/151, August 7, 2020).