RDP 2007-07: More Potent Monetary Policy? Insights from a Threshold Model 4. Conclusions

The behaviour of the economy to a range of shocks may depend on conditions in the market for credit. This paper has presented indirect evidence for the proposition that credit constraints could lead to asymmetric responses to changes in monetary policy using a threshold model to capture nonlinear relationships in the data. There is evidence of regimes switching, whereby interest rate changes appear to have a larger effect on economic activity in the regime with low credit growth, which is likely to characterise periods when credit constraints are more pervasive.

This may appear to be at odds with the notion that increasing household indebtedness – following a period of relatively rapid credit growth – would, by itself, suggest that household cash flows may be more responsive to interest rate changes. However, two other factors could be at work. First, the business sector is less indebted than it had been in the late 1980s and early 1990s. Second, relatively strong credit growth in recent years is consistent with the notion that households appear able to smooth consumption in the face of temporary shocks to disposable income. Nevertheless, it is conceivable that a long period of rapid credit growth and rising indebtedness could at some point lead to more constrained credit conditions in the future.