An Empirical Study Of Financial Conditions Index As An Indicator Of Monetary Policy Based On The Generalized Dynamic Factor Model

The2008global financial crisis emphasized the importance of asset prices, whose dramatic changes have led to a global economic disaster. Meanwhile, with the deepening of China’s financial market, changes in financial markets and asset prices have significantly affected the role of monetary policy on the real economy. So it’s meaningful for us to build an observable multi-dimensional indicator which could reflect the changes in asset prices and financial conditions.In this paper, the observable multi-dimensional indicator is financial conditions index(FCI),which is established with the generalized dynamic factor model with the help of previous studies.This index excludes the impact of the economic cycle to represent the "pure" financial shocks, and it can assess overall financial conditions and changes in asset prices.Through the empirical research, FCI is a predictive leading indicator for the economy by Granger causality test and correlation coefficient test. Furthermore, We decompose FCI into different variables to see the time-varying roles of financial activities. And fluctuations in stock price and real estate price have a larger effect on the FCI and economy than that of interest rate and exchange rate. At last, we carry out formal predictive power tests to investigate the index’s ability to predict the macro economy which is done both in-sample and out-sample following Bernanke’s equation.