How Credit Affects the Business Cycle

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Nice piece in the monthly St. Louis Fed’s Monetary Trends, for September.

A prominent view in economics is that malfunctioning credit markets “are not simply passive reflections of a declining real economy, but are in themselves a major factor depressing economic activity.”1 This view has greatly influenced monetary policy.

A clear example is the recent “Great Recession,” when financial markets became volatile and illiquid and the viability of some of the world’s leading financial institutions was seriously in doubt. Federal Reserve policymakers responded aggressively by lowering interest rates to near zero, implementing lending facilities, and instituting multiple rounds of quantitative easing, parts of which were aimed directly at supporting the functioning of the financial system. Analyses linking the performance of financial markets to aggregate economic activity typically have a financial accelerator mechanism at their core. Fed Chairman Ben Bernanke eloquently summarizes the workings of this mechanism in a recent speech.2 Here, I interpret movements in business credit demand and liquid asset holdings in terms of this theory.

The key links between the workings of the financial system and real economic activity are easily understood. Entrepreneurs may develop profitable projects and firms may find it profitable to expand or invest more. Both actions typically require tapping credit markets to obtain required resources. Access to credit, however, is limited by the presence of asymmetric information and principal-agent problems, which are natural in credit relations. Financial institutions appropriately monitor borrowers to help overcome these frictions.”

The regular monthly Monetary Trends PDF is chock full of wonderful charts and graphs . . .

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Source:
How Credit Affects the Business Cycle
Adrian Peralta-Alva
Monetary Trends, September 2011
Federal Reserve Bank of St. Louis, August 2011
http://research.stlouisfed.org/publications/mt/

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1 Bernanke, Ben S.; Gertler, Mark and Gilchrist, Simon. “The Financial Accelerator
in a Quantitative Business Cycle Framework,” in John B. Taylor and Michael
Woodford, eds., Handbook of Macroeconomics. Chap. 21. Amsterdam: Elsevier,
pp. 1341-393.

2 Bernanke, Ben S. “The Financial Accelerator and the Credit Channel.” Presented
at the Federal Reserve Bank of Atlanta Conference, Credit Channel of Monetary
Policy in the Twenty-First Century, June 15, 2007; www.federalreserve.gov/
newsevents/speech/Bernanke20070615a.htm