RDP 2012-02: The Role of Credit Supply in the Australian Economy 2. Credit Frictions in Theory

Many early scholars of the Great Depression saw credit market developments as central to explaining the length and depth of that crisis.^[4] However, the importance of credit frictions and balance sheets largely fell out of favour in the macroeconomics literature over subsequent decades, as documented by Gertler (1988).^[5] Attention shifted to the primary importance of monetary aggregates and price rigidities (notably Friedman and Schwartz (1963)).

Accordingly, with some notable exceptions, New Keynesian models at the heart of modern monetary economics generally had not incorporated frictions in the financial market up until recently. Rather, frictions were added as a feature of the goods market in terms of price stickiness or the labour market in terms of wage rigidity. In theoretical terms, abstracting from financial markets can be justified if financial markets are thought to be ‘frictionless’, with complete information and an ability to hedge perfectly against any risk. In such a world, finance is supplied elastically at the risk-free rate, and so the financial market is a ‘passive participant’ in general equilibrium. This assumption underlies both the canonical New Keynesian and real business cycle models' treatment of the financial market.

Bernanke (1983) marked the start of a revival of interest in the importance of financial frictions for the macroeconomy. He demonstrated empirically that financial factors held substantial explanatory power over and above purely monetary explanations for the Great Depression. Since the global financial crisis there has been a further resurgence of interest in modelling financial frictions and their importance for the real economy.

A key departure from the assumption of frictionless markets is information asymmetry, which is endemic in financial market contracts.^[6] Borrowers are more informed than lenders with regard to the use of, and likely return on, borrowed funds, which presents lenders with the usual agency costs such as adverse selection, moral hazard and monitoring costs (e.g. Stiglitz and Weiss 1981). These agency costs act as a friction against the supply of credit and can manifest themselves in two main ways:

• An external finance premium. Borrowers will pay a premium for accessing external funding, increasing the price of finance.
• Non-price contract terms. Lenders may seek to alleviate agency problems through ‘non-price’ aspects of financial contracts; for example, borrowers may be required to post minimum collateral (e.g. a loan-to-valuation ratio limit) or provide minimum documentation. The need to meet these contract terms can restrict the quantity of finance available to borrowers.

In turn, credit frictions can have broad implications for the macroeconomy. In particular:

• Credit frictions affect real activity. Credit frictions increase the marginal cost and reduce the availability of finance – in effect, credit supply is no longer perfectly elastic. This results in a smaller equilibrium capital stock in the economy. Moreover, credit supply may shift in a manner that amplifies the business cycle. A downturn in the real economy weakens firms' and households' balance sheets, leading to an increase in the external finance premium and tighter non-price terms in loan contracts, amplifying the initial shock. The reverse is also true; frictions are alleviated during periods of strong economic growth, providing additional stimulus to real activity. Moreover, as well as propagating shocks within the economy, the credit market can also be a source of shocks.
• Credit frictions play a part in policy transmission. Credit frictions may give rise to an additional ‘credit channel’ of monetary policy transmission. An increase in policy rates lowers both asset values and cash flows to businesses and households, reducing their creditworthiness. In turn, this leads to a rise in the external finance premium and tighter contract terms, which amplifies the initial policy tightening.

A group of theoretical models has embedded these mechanisms in a general equilibrium setting – these are broadly referred to as ‘financial accelerator’ models (Carlstrom and Fuerst 1997; Kiyotaki and Moore 1997; Bernanke, Gertler and Gilchrist 1999).^[7] While the financial accelerator mechanism operates through the investment activities of firms, credit frictions may also affect aggregate demand through other components of expenditure. In particular, residential investment, consumption, trade and inventories might all be affected by the availability of credit (Pagan and Robinson 2011).

Footnotes

Most notably, Fisher (1933) placed heavy emphasis on factors such as over-indebtedness and the crippling deterioration in borrower balance sheets caused by the combination of deflation and nominal debt contracts. [4]

There were notable exceptions, e.g. Gurley and Shaw (1955). [5]

Frictions other than information frictions may also operate. For example, if lenders are not perfectly competitive and risk neutral, then the external finance premium also reflects risk aversion and profit margin. In this case, credit supply may also shift due to changes in industry structure (e.g. financial deregulation) or the attitude of intermediaries toward risk. [6]

Earlier work integrated credit market frictions into an IS-LM framework (Bernanke and Blinder 1988). This operated through a ‘bank lending channel’ which is irrelevant for Australia (as discussed in footnote 3). [7]