Feedbacks: Financial Markets and Economic Activity

Is credit expansion a sign of desirable financial deepening or the prelude to an inevitable bust? We study this question in modern US data using a structural VAR model of 10 monthly frequency variables, identified by heteroskedasticity. Negative reduced-form responses of output to credit growth are caused by endogenous monetary policy response to credit expansion shocks. On average, credit and output growth remain positively associated. Financial stress shocks to credit spreads cause declines in output and credit levels. Neither credit aggregates nor spreads provide much advance warning of the 2008-2009 crisis, but spreads improve within-crisis forecasts.

Automated summary

The study using modern US data shows that the negative impact of credit expansion on output is due to the endogenous monetary policy response to credit expansion shocks. On average, credit growth and output growth remain positively correlated, but financial stress shocks on credit spreads can cause declines in output and credit levels. Credit aggregates and spreads did not provide much advance warning of the 2008-2009 crisis, but they did improve within-crisis forecasts.