Business cycles, financial conditions and nonlinearities

This paper proposes a conceptualization of business cycle fluctuations in which the role of financial conditions and nonlinear dynamics are explicitly incorporated. We highlight the role of investment demand in driving economic fluctuations, consider its endogenous dynamic interactions with profitability and aggregate demand levels as well as financial conditions, emphasize that the sources of instability in an economy cannot be associated exclusively with the real or financial sectors, and incorporate the idea that financial conditions are both important sources of instability and possible nonlinear propagators of other sources of instability. We test the propagation mechanisms of such conceptualization using a Bayesian Threshold Vector Autoregression model for the US economy. The results support the characterization of nonlinear dynamics in the transmission of shocks since there is evidence of asymmetric responses of the variables across two different regimes of financial stress, responding more strongly during loose financial conditions.