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This paper explores the relationship between the health of the financial sector and the rest of the economy. The author develops an indicator of financial sector health using a distance-to-default measure based on a Merton-style option pricing model. The measure spans over three decades and appears to capture periods when financial sector institutions were strong and when they were weak. The author then use vector autoregressions to assess whether the indicators of financial-sector health affects the real economy, in particular non-residential investment. The results indicate that the measure has a considerable impact.
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