The Transmission Mechanism and Financial Stability Policy

Report from the Economic Affairs Department at the Ministry of Finance.

This paper identifies negative externalities in the financial system and describes how they affect the real economy through various channels in the transmission mechanism. This serves as the basis for a new broader approach to Financial Stability Policy compared to Macroprudential Policy. Next, a small scale macroeconomic VAR model is developed, including financial indicator variables that allow the separate study of each of the theoretically identified transmission channels. The model is then used for stress tests and also to simulate the effects from financial shocks on the real economy from using two policy instruments: countercyclical capital buffers and loan-to-value ratio.