Financial imbalances and macroeconomic tail risks : a structural regime-switching investigation

We first empirically document that excessive credit growth and asset price overvaluations raise the likelihood of financial crises and deepen the severity of associated economic downturns in advanced economies using linear probability models and local projections. We then rationalise these empirical findings in a Markov regime-switching version of a canonical New Keynesian DSGE model with the banking and housing sectors estimated for the euro area, which explicitly accounts for prolonged financial cycles based on hybrid house-price expectations and the nonlinearities arising from financial imbalances. The model offers a framework in which low-probability financial crashes are nested within typical business cycles. We then present several policy applications to show how this framework can be used to conduct structural macro-financial risk analysis depending on the evolution of financial conditions and to assess monetary and macroprudential policies, uncovering key policy trade-offs.