Measuring real–financial connectedness in the U.S. economy

• Published in: The North American journal of economics and finance 2021-11, Vol.58, p.101554, Article 101554
• Main Authors: Uluceviz, Erhan, Yilmaz, Kamil
• Format: Article
• Language: English
• Subjects: ADS index; Connectedness; Dynamic factor model; Macro-financial linkages; Variance decomposition; Vector autoregression; Volatility
• ISSN: 1062-9408; 1879-0860
• DOI: 10.1016/j.najef.2021.101554

We analyze the connectedness between the real and the financial sectors of the U.S. economy. Using the weekly ADS index of the Philadelphia Fed (the widely used business conditions indicator) to represent the real side, we find that during times of financial distress and business cycle turning points, the direction of connectedness runs from the real sector to financial markets. The ADS index is derived from a model containing a measure of term structure along with real variables. Therefore, it might not be the best representative of the real activity used in the connectedness analysis. As an alternative, we derive a real activity index (RAI) from a dynamic factor model of the real sector variables only. The behavior of RAI over time is quite similar to that of the ADS index. When we include RAI to represent the real side, connectedness from the real side to financial markets weakens substantially, while the connectedness from financial markets to the real side becomes more pronounced. •We study real–financial connectedness in the U.S. economy in a network setup.•Philadelphia Fed’s business conditions index, ADS, uses real and financial variables.•Using real variables only we estimate the proper measure: real activity index, RAI.•Proxied by ADS, real sector generates net connectedness towards financial markets.•Proxied by RAI, real sector receives net connectedness from financial markets.