The importance of credit demand for business cycle dynamics

Abstract

This paper contributes to a better understanding of the important role that credit demand plays for credit markets and aggregate macroeconomic developments as both a source and transmitter of economic shocks. I an the first to identify a structural credit demand equation together with credit supply, aggregate supply, demand and monetary policy in a Bayesian structural VAR. The model combines informative priors on structural coefficients and multiple external instruments to achieve identification. In order to improve identification of the credit demand shocks, I construct a new granular instrument from regional mortgage origination. I find that credit demand is quite elastic with respect to contemporaneous macroeconomic conditions, while credit supply is relatively inelastic. I show that credit supply and demand shocks matter for aggregate fluctuations, albeit at different times. Credit demand shocks mostly drove the boom prior to the financial crisis, while credit supply shocks were responsible during and after the crisis itself. In an out-of-sample exercise, I find that the Covid pandemic induced a large expansion of credit demand in 2020Q2, which pushed the US economy towards a sustained recovery and helped to avoid a stagflationary scenario in 2022.