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IS IT MONEY OR CREDIT, OR BOTH, OR NEITHER?'
Credit, Money, and Aggregate Demand
By
B en
S.
Bernanke
and
Most standard models of aggregate de
mand, such as the textbook IS /L M model,
treat bank assets and bank liabilities asym
metrically. Money, the bank liability, is given
a special role in the determination of aggre
gate demand. In contrast, bank loans are
lumped together with other debt instruments
in a “ bond market,” which is then conve
niently suppressed by Walras’ Law.
Much recent research provides reasons to
question this imbalance. A growing theoreti
cal literature, based on models with asym
metric information, stresses the importance
of intermediaries in the provision of credit
and the special nature of bank loans. Empiri
cally, the instability of econometric moneydemand equations has been accompanied by
new interest in the credit-GNP relation
ship (see especially the work of Benjamin
Friedman).
We have developed several models of ag
gregate demand which allow roles for both
money and “ credit” (bank loans). We pre
sent a particularly simple one, a variant of
model, in this paper.
Though it has a simple graphical represen
tation like IS /L M , this model permits us to
pose a richer array of questions than does
the traditional money-only framework.
A
lan
S.
B l in
der
*
credit are viewed as perfect substitutes for
auction-market credit (“ bonds” ), and finan
cial markets clear only by price. Models with
a distinct role for credit arise when either of
these assumptions is abandoned.
Following James Tobin (1970) and Karl
Brunner and Allan Meltzer (1972). wc choose
to abandon the perfect substitutability as
sumption and ignore credit rationing .1 Our
model has three assets: money, bonds, and
loans. Only the loan market needs explana
tion. We assume that both borrowers and
lenders choose between bonds and loans
according to the interest rates on the two
credit instruments. If p is the interest rate on
loans and / is the interest rate on bonds,
then loan demand is: L d * U p , v). The
dependence on GNP ( y ) captures the trans
actions demand for credit, which might ansc.
for example, from working capital or liquid
ity considerations.
To understand the genesis of loan supply,
consider a simplified bank balance sheet
(which ignores net worth) with assets: re
serves, R\ bonds, B h\ loans, L*\ and liabili
ties: deposits, D. Since reserves consist of
required reserves, rZ), plus excess reserves.
£ , the banks’ adding-up constraint is: B h +
L s + E * D (\ - t). Assuming that desired
portfolio proportions depend on rates of re
turn on the available assets (zero for excess
reserves), we have L* ** \ ( p . i)D ( 1 - r). with
similar equations for the Shares of B h and
E. Thus the condition for clearing the loan
market is
I. The Model
The LM curve is a portfolio-balance conition for a two-asset world: asset holders
oose between money and bonds. Tacitly,
oans and other forms of customer-market
(1)
L ( p , f, .y) * A(p, i)Z)(l - T)
Cu.riiSaf sants: Charts Freedman, Bank of Canada;
Plosscr, University of Rochester; Robert H.
Michigan State University.
*l*ri?ccton University, Princeton, NJ 08544. We are
*™eful to the NSF for supporting this research.
‘Blinder (1987) offer* a model in which there i&
rationing and no substitute for bank credit
435
AEA PAPERS AN D PRO CEEDING S
436
M A Y 1988
The money market is described by a con
ventional LM curve. Suppose banks hold
excess reserves equal to c ( /) £ )(l- r ) .2 Then
the supply of deposits (we ignore cash) is
equal to bank reserves, R , times the money
multiplier, m (i) = [f(/)( 1 - r ) + t ) ] -1. The
demand for deposits arises from the transac
tions motive and depends on the interest
rate, income, and total wealth, which is con
stant and therefore suppressed: D (i,y).
Equating the two gives
(2)
D (i,y ) = m ( i) R .
Implicitly, /)(/, y ) and L ( p J , y ) define the
nonbank public’s demand function for bonds
since money demand plus bond demand
minus loan demand must equal total finan
cial wealth.
The remaining market is the goods market,
which we summarize in a conventional IS
curve, written generically as 3
(3)
y = Y(L>e).
II. Graphical Representation
Use (2) to replace D( 1 - t ) on the righthand side of (1 ) by (1 - r )m (i)R . Then ( 1 )
can be solved for p as a function of i, y, and
R :4
(4)
P = <#>(', ^,-R ).
Finally, substitute (4) into (3) to get
(5)
y = Y (iM i> y , R ) ) ,
which, in deference to Don Patinkin (1956),
2 F or simplicity we assume that only i, not p, influences the demand for excess reserves.
3 The interest rates in (3) should be real rates. But a
model of aggregate demand takes both the price level
and inflation as given; so we take the expected inflation
rate to be constant and suppress it.
P is an increasing function of / as long as the
interest elasticity of the money multiplier is not too
large.
F ig u r e 1
we call the CC curve (for “ commodities and
credit”). It is easy to see that the CC curve is
negatively sloped like an IS curve, and for
much the same reasons. However, it is shifted
by m onetary policy ( R ) and by credit-market
shocks that affect either the L(*) or A( )
functions, while the IS curve is not. The
CC and LM curves are shown together in
Figure 1 .
O ur C C curve reduces to the IS curve if
loans and bonds are assumed to be perfect
substitutes either to borrowers ( L p - * - 00)
or to lenders (A p -> o o ), or if commodity
dem and is insensitive to the loan rate ( Yp
= 0 ) —which would make the loan market
irrelevant to I S /L M . This clarifies the spe
cial assum ptions implicit in the money-only
view.
The opposite extreme, or credit-only view,
would arise if money and bonds were perfect
substitutes (D i -> - oo), which would make
the LM curve horizontal. Keynes’ explana
tion for the liquidity trap is, of course, we
known. We think of high substitutability as
more likely to arise from financial innova
tions which create new money substitutes.
However, even with a liquidity trap, mone
tary policy still m atters because it influences
the CC curve.
Now let us turn to the intermediate cases
represented by Figure 1.
VOL. 78 NO. 2
I S I T M O N E Y OR CREDIT\ OR BOTH, OR N E ITH E R ?
III. Comparative Statics5
Most conventional shocks work in our
model just as they do in IS /L M . For exam
ple, an expenditure shock shifts the CC curve
along a fixed LM curve, and a moneydemand shock shifts the LM curve along
a fixed CC curve. The effects are familiar
and need not be discussed. The only note
worthy difference is that a rise in bank re
serves might conceivably raise the rate of
interest in the credit model. Graphically, the
ambiguity arises because an increase in R
shifts both the CC and LM curves outward.
Economically, the credit channel makes
monetary policy more expansionary than in
IS /L M and therefore raises the transactions
demand for money by more than in the
conventional model.
Greater interest attaches to issues that
elude the IS /L M model. An upward shift in
the credit supply function, X(-) (which might
correspond, for example, to a decrease in the
perceived riskiness of loans) shifts the CC
curve outward along a fixed LM curve,
thereby raising i and y. The interest rate on
loans, p, falls, however. An upward shift in
the credit dem and function, L (-), which
might correspond to a greater need for work
ing capital, has precisely the opposite effects.
We find it difficult to think of or identify
major shocks to credit demand, that is, sharp
increases or decreases in the dem and for
loans at given interest rates and GNP. But
shocks to credit supply are easy to con
ceptualize and to find in actual history. For
example, Bem anke’s (1983) explanation for
the length of the G reat Depression can be
thought of as a downward shock to credit
supply stemming from the increased riski
ness of loans and banks’ concern for liquid!ty m the face of possible runs. According to
t-
^ comparative statics results require no assumpns °ther than the ones we have already made. But, in
we ^ c o u n te r theoretical ambiguities that
tinn
r^ ved by invoking certain elasticity assump_ i . spelled out in a longer version of this paper. If
bv p . 1S
on the supply side, y would be replaced
w Figure 1 and in the text discussion that follows.
437
the model, such a shock should reduce credit,
GN P, and the interest rate on government
bonds while raising the interest rate on loans.
Another notable example with the same pre
dicted effects is the credit controls of
March-July 1980. In this instance “ tight
money” should, and apparently did, reduce
interest rates on government bonds.
IV. Implications for Monetary Policy
We turn next to the traditional target and
indicator issues of monetary policy. The socalled monetary indicator problem arises if
the central bank sees its impact on aggregate
dem and only with a lag but sees its impacts
on financial-sector variables like interest
rates, money, and credit more promptly.
W hat does our model say about the suitabil
ity of money or credit as indicators?
Table 1 shows the qualitative responses of
GNP, money, credit, and bond interest rates
to a wide variety of shocks, assuming that
bank reserves is the policy instrument. Col
umns 1 and 2 display a conclusion familiar
from IS /L M : money is a good qualitative
indicator of future GNP movements except
when money demand shocks are empirically
im portant. Columns 1 and 3 offer the corre
sponding conclusion for credit: credit is a
good qualitative indicator except when there
are im portant shocks to credit demand. If
money demand shocks were indeed more
im portant than credit demand shocks in the
1980’s, credit would have been a better indi
cator than money.
W hat about the target question, that is,
about the choice between stabilizing money
vs. stabilizing credit? Rather than try to con
duct a complete Poole-style (1970) analysis,
we simply ask whether policymakers would
respond “correctly” (i.e., in a stabilizing way)
to various shocks if they were targeting mon
ey or targeting credit.
Consider first an expansionary IS shock.
Table 1 (line 5) shows that both money and
credit would rise if bank reserves were un
changed. Hence a central bank trying to
stabilize either money or credit would con
tract bank reserves, which is the correct
stabilizing response. Either policy works, at
least qualitatively. A similar analysis applies
AEA PAPERS AND PROCEEDINGS
T able 2 — S im pl e C o r r e la tio n s of G rowth Ra m
o f G N P w it h G r o w t h R ates of
F in a n c ia l A g g r e g a t e s , 1973-85* h
T a b u 1 E m m o f Shoc ks o n
O b s e rv a b le V a r ia b le s
(1)
Income
Ri*r tn
B«nk R c « n c »
M onc> D em and
C red it Supply
C red it D em and
C o m m o d ity D em and
(2)
Money
(3)
Credit
4
•f
♦
-f
+
4
-f
*
(4)
Interest
R ate -
+
♦
+
*(>n bond*
to shocks to the supply of credit or to the
money multiplier.
But suppose the demand for money in
creases (line 2 ), which sends a contractionary
impulse to GNP. Since this shock raises Af,
a monetarist central bank would contract
reserves in an effort to stabilize money, which
would destabilize GNP. This, of course, is
the familiar Achilles heel of monetarism.
Notice, however, that this same shock would
make credit contract. So a central bank try
ing to stabilize credit would expand reserves.
In this case, a credit-based policy is superior
to a money-based policy.
The opposite is true, however, when there
are credit-demand shocks. Line 4 tells us
that a contractionary (for GNP) creditdemand shock lowers the money supply but
raises credit. Hence a monetarist central bank
would turn expansionary, as it should, while
a creditist central bank would turn contrac
tionary. which it should not.
We therefore reach a conclusion similar to
that reached in discussing indicators: If
monev-demand shocks are more important
than credit-demand shocks, then a policy of
targeting credit is probably better than a
policy of targeting money.
V. Empiric*] Evidence
The foregoing discussion suggests that the
case for credit turns on whether credit de
mand is, or is becoming, relatively more
stable than money demand. We conclude
with some evidence that this is true, at least
since 1979.6
6In
follows, “ money” is A/1, “ credit” is an
aggregate invented by one of us: the sum of intermedi
ated borrowing by households and businesses (derived
MA Y l m
Period
1 9 5 3 :1 -1 9 7 3 :4
1 974:1-1979:3
1 9 7 9 :4 -1 9 8 5 :4
With Money
With Credit
.51,.37
.50,.54
.11,.34
.17. 11
.50, 51
.38. 4"
“ G ro w th ra te s are first differences of natural loga
rithm s.
b C o rrelatio n s in nom inal term s come first; correla
tions in real term s com e second.
Table 2 shows the simple correlations be
tween G N P growth and growth of the two
financial aggregates during three periods
Money was obviously much more highly cor
related with income than was credit during
the period of stable money demand, 1953- 73
But the two financial aggregates were on a
more equal footing during 1974:1-1979:3.
Further changes came during the period of
unstable money demand, 1979:4—1985:4;
m oney-G NP correlations dropped sharply
while money-credit correlations fell onl>
slightly, giving a clear edge to credit.7
M ore direct evidence on the relative
magnitudes of money-demand and creditdem and shocks was obtained by comparing
the residuals from estimated structural money-demand and credit-demand functions like
D ( ) and L ( ) in our model. We used the
logarithmic partial adjustment model, wit
adjustm ent in nominal terms, which we are
not eager to defend but which was design
to fit money demand. Hence, our procedure
seems clearly biased toward finding re a
tively larger credit shocks than money shoe s
Unsurprisingly, estimates for the enure
1953-85 period rejected parameter stabiM
across a 1973:4-1974:1 break, so we con
centrated on the latter period .8 Much to ou
from Flow -of-Funds data). F or details and anahwthe latter, see Blinder (1985).
y
7Similar findings emerged when we c001™
m any variables via a v e c t o r - autoregression and
at correlations betw een VAR residuals.
in$tn»8Estim ation was by instrum ental
^
m ents were current, once, and twice lagged
^
government purchases, real exports, bank
a supply shock variable which is a weighted a .^
the relative prices of energy and agncultural p
IS I T M O N E Y OR CREDIT, OR BOTH, OR NEITH ER?
VOL. 78 NO. 2
amazement, we estimated moderately sensi
ble money and credit demand equations for
the 1974:1—1985:4 period on the first try
(standard errors are in parentheses):
logM = - .06 + ^ l o g M . i - .2 2 2 /
(.34) (.059)
(.089)
+ .0831ogP+ .0121og>>
(.052)
(.059)
SE E = .00811
D W = 2.04,
log C = - 1.75 + .885 log C_ x— .424p
(0.63) (.076)
(.285)
439
measure, the variance of money-demand
shocks was much smaller than that of
credit-demand shocks during the first sub
period but much larger during the second.
The evidence thus supports the idea that
money-demand shocks became much more
im portant relative to credit-demand shocks
in the 1980’s. But that does not mean we
should start ignoring money and focusing on
credit. After all, it is perfectly conceivable
that the relative sizes of money-demand and
credit-demand shocks will revert once again
to what they were earlier. Rather, the mes
sage of this paper is that a more symmetric
treatm ent of money and credit is feasible
and appears warranted.
+ .514/ + .0751ogP+ .292log y
(.389) (.086)
(.107)
REFERENCES
SE E = .00797,
D W = 2.44.
Here y is real GNP, P is the G N P deflator,
p is the bank prime rate, and i is the threemonth Treasury bill rate. Although the inter
est rate coefficients in the credit equation are
individually insignificant, they are jointly
significant, have the correct signs, and are
almost equal in absolute value— suggesting a
specification in which the spread between p
and i determines credit demand. Notice that
the residual variances in the two equations
are about equal.
Since the sample was too short to test
reliably for param eter stability, we examined
the residuals from the two equations over
two subperiods with these results:
period
1^740-1979:3
1979:4-1985:4
variance of
money
residual
variance of
credit
residual
.2 6 5 x 1 0 '4 .687 X l O 4
.888 XlO-4 .435 XlO-4
The differences are striking. By this crude
Bemanke, Ben S., “ Nonmonetary Effects of
the Financial Crisis in the Propagation of
the Great Depression,” American Eco
nomic Review, June 1983, 75, 257-76.
Blinder, Alan S., “ Credit Rationing and Effec
tive Supply Failures,” Economic Journal,
June 1987, 97, 327-52.
______ , “ The Stylized Facts About Credit
Aggregates,” mimeo., Princeton Univer
sity, June 1985.
Brunner, Karl and Meltzer, Alan H., “ Mon
ey, Debt, and Economic Activity,” Journal
o f Political Economy, September/October
1972, 80, 951-77.
Patinkin, Don, Money, Interest, and Prices,
New York: Harper and Row, 1956.
Poole, William, “ Optimal Choice of Monetary
Policy Instruments in a Simple Stochastic
Macro Model,” Quarterly Journal of Eco
nomics,, May 1970, 2,197-216.
Tobin, James, “ A General Equilibrium Ap
proach to Monetary Theory,” Journal of
Money, Credit and Banking, November
1970, 2, 461-72.
@FedFRASER