Sources of business cycle fluctuations and financial spillovers

Abstract

This thesis studies the importance of non-fundamental factors in economic and financial fluctuations. In particular, it studies how the economy responds to changes in expectations about economic fundamentals, independently of actual changes in those fundamentals, and to what extent financial fluctuations in one country spillover to other countries. The first chapter investigates how the economy reacts to the arrival of news about future technological progress. I find that the economy expands following a so-called news shock, but the bulk of the effect is delayed until technology starts to actually improve. News shocks explain around 30 percent of business cycle fluctuations, while their role is more important for explaining variations in forward-looking variables, such as stock prices and the term spread. In the second chapter, jointly written with Stephane Dées, studies the importance of animal spirits - defined as changes in expectations not supported by changes in fundamentals - for producing business cycles. We find that animal spirits are more important for business cycle fluctuations than permanent shocks. We use a novel identification scheme in a vector-autoregressive framework that exploits the fact that the econometrician has a richer data-set than consumers. In the third chapter, jointly written with Roberto De Santis, studies the extent and direction of spillovers, contagion and connectedness in European and US sovereign debt markets from 2005 to 2014. We use a new method that allows us to identify orthogonal country specific shocks in a panel of countries, employing restrictions on the relative size of the contemporaneous impact effect. We find that connectedness declined steadily between 2009 and 2012, indicating increased financial fragmentation. We find that Greece was a key source of systemic risk in 2010, explaining 20-30% of the variance of sovereign yields in stressed countries, while in 2011-2012 Italy, not Spain, was a key source of systemic risk.