How do credit supply and demand influence business cycle dynamics?

Abstract

The objective of this project is to quantify the relative importance of credit demand and credit supply shocks in determining fluctuations in credit variables and the business cycle. Since the financial crisis, the volume of credit has been the linchpin of policymaking geared toward financial stability and macroprudential policy. For example, the credit-to-GDP gap is key in the Basel III regulation and the setting of countercyclical capital buffers, and private credit stocks and flows are among the scoreboard indicators employed for the European macroeconomic imbalances procedure. These two regulatory initiatives monitor the developments of credit volumes, but focus on different sides of the market. Countercyclical capital buffers are aimed at regulating credit supply, while the scoreboard has an eye on firm and household (over-)indebtedness and hence credit demand. Thus, understanding to what extent fluctuations are due to demand or supply is crucial for formulating policy and for assessing the macroeconomic implications. Using a novel approach to identification that combines multiple sources of information, this project aims at disentangling credit supply and credit demand shocks to examine their dynamic effects on the real economy and their contributions to historical fluctuations in credit volumes.