Credit creation, monetary policy and the macroeconomy: three empirical studies

Abstract

This thesis is composed of three empirical studies examining the relationship between credit creation, monetary policy and macroeconomic activity. It is motivated by the neglect of credit in mainstream macroeconomic theory and empirical work prior to the financial crisis of 2007-08.

The first study investigates the relationship between monetary policy and nominal GDP in the United Kingdom over 50 years using a new quarterly dataset. Different theories of the monetary transmission mechanism are tested using the ‘General-to-Specific’ (GETS) method. A long-run cointegrating relationship is found between a real economy credit growth variable and nominal output growth. Changes to short-term interest-rates and broad money growth fall out of the parsimonious model. Vector error correction and vector auto-regression (VAR) analysis finds one- way Granger causality from credit growth to nominal-GDP growth.

The second study examines evidence of a ‘credit cycle’ by analyzing the dynamic interlinkages between credit, house prices, monetary policy, and economic activity in nine advanced economies. Credit is decomposed in to ‘productive credit’ (bank lending to non-financial firms and for consumption) and ‘asset market credit’ (lending for domestic mortgages or financial assets). Country-level and panel VAR analysis finds: 1) a secular growth in asset market credit relative to productive credit; 2) productive credit growth has a stronger impact on real-GDP growth than asset-market credit although there is cross-country heterogeneity; (3) property prices strongly influence both credit growth aggregates and the macroeconomy; and (4) interest rates are more weakly linked to the other variables.

The third study considers the monetary financing of government expenditure by central- banks as a monetary policy tool. This is pertinent today given historically high private and public debt-to-GDP levels. A literature review finds little support for the standard claim that such activity leads to damaging inflation. A counter-example is presented via an institutional case study of the central bank of Canada during the period 1935-1975 when it monetised on average 25% of government debt to support fiscal expansion and economic growth. Econometric analysis also finds no evidence for a relationship between monetary financing and inflation.

The policy implications of the thesis are that: 1) credit growth plays a central role in the monetary policy transmission mechanism; 2) there is evidence of a credit cycle strongly related to house prices in advanced economies which may be strengthening over time; and 3) monetary financing of government deficits should be considered as a policy tool given high private debt levels and private banks’ turn towards asset market credit creation.

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