This study tests for the state-dependent response of monetary policy to increases in overall financial stress and financial sector-specific stress across a panel of advanced and emerging economy countries. We use a factor-augmented dynamic panel threshold regression model with (estimated) common error components to deal with cross-sectional dependence. We find strong evidence of advanced economy countries’ aggressive monetary policy loosening in response to stock market and banking stress but only in times of high financial market volatility. By comparison, evidence of threshold effects of financial stress is generally weak for emerging market countries’ interest rate decisions.

Motivation

Recent empirical evidence shows that the monetary policy response to episodes of financial turmoil have not been always the same and is generally asymmetric (see Bean, Paustian, Penalver, & Taylor, 2010). The global financial crisis is one such example. The financial crisis of 2007–۲۰۰۸ solicited more aggressive and unprecedented interest rate cuts in advanced economies (AEs) as well as emerging market economies (EMEs) compared to the bursting of the dotcom bubble in 2001 or the Asian financial crisis in 1997. Given that financial stress events occur infrequently and the intensity and sources of these events are not the same, it is thus natural to consider a possible nonlinear relationship between monetary policy and financial stress