RDP 2012-02: The Role of Credit Supply in the Australian Economy 7. Conclusion

The global financial crisis highlighted the importance of well-functioning credit markets for the real economy. In Australia and abroad, tighter credit conditions along with reduced demand led to a sharp decline in business and household credit, and this was associated with weaker investment and consumption. Previous research has made a qualitative assessment of the relative importance of credit supply and demand factors during this time, but has not determined their quantitative significance. This paper identifies and measures the importance of shocks to credit supply over the past three decades and so provides estimates of the impact of those shocks during the recent financial crisis.

Based on a structural VAR model incorporating a survey measure of the difficulty obtaining finance, shocks to credit supply are shown to have a significant effect on the real economy. A one standard deviation shock to credit supply (a 5½ percentage point increase in the balance of firms recording a tightening in financing conditions) is estimated to lower GDP by nearly ⅓ per cent after one year and business credit by almost 1 per cent after two and a half years. Credit supply shocks are also found to be of material importance during earlier credit cycles. During the global financial crisis, the cumulative impact of credit supply shocks is estimated to have reduced GDP by 1 per cent (in mid 2009), one of the largest subtractions since financial deregulation in the 1980s. However, the effect of the global financial crisis on activity via credit supply appears to have been shorter and sharper than that experienced during the period of financial instability in the early 1990s.

This paper also presents evidence of a ‘credit channel’ of monetary policy transmission, with unexpected changes to monetary policy having a discernible impact on financing conditions. Finally, the results are consistent with the existence of a financial accelerator mechanism in the Australian economy, as positive shocks to net worth reduce the difficulty and cost of obtaining finance, leading to higher GDP and credit growth.

Altogether, these results suggest that credit market developments have had an important bearing on the Australian economy since financial deregulation in the 1980s, and that the credit channel and financial accelerator mechanism have roles to play in the transmission of monetary policy in Australia.