RDP 8803: Do Financial Aggregates Lead Activity?: A Preliminary Analysis 2. Relationships between Money, Credit and Activity

There is a school of thought (e.g. Laidler, 1985) that argues that monetary aggregates are linked with spending through a real balance effect. Individuals or companies are assumed to have a desired stock of real money balances, which is typically thought to depend on income and the opportunity cost of holding money rather than some other asset. If the actual level of real balances falls below the desired level, people will curtail spending and sell other assets to rebuild their balances. If balances are too high, people will seek to reduce them, adjusting their portfolios by purchasing other assets and by final spending on goods and services.

Within this framework, in which the nominal stock of money is supply-determined but the real stock is demand-determined, an “exogenous” increase in the stock of money would be expected to lead to an increase in expenditure on goods and services.

An alternative framework treats the supply of money as adjusting passively to the demand for money. In this case, money could move contemporaneously with, or possibly even lag economic activity through the income effects on the demand for money. A leading relationship would not necessarily be expected.

The relationship between credit aggregates and economic activity is looked at from a slightly different perspective to the link between money and activity. The decision to borrow is a decision to spend today more than today's income, against the capacity to repay of tomorrow's expected income. For consumers, the borrowing decision is closely related to movements in income, to assessments of whether those movements are transitory or permanent, and to the level of interest rates. For business, borrowing for working capital purposes will be a similar decision. When considering borrowing for investment purposes, businesses' decisions will be influenced by present and expected future profitability, the relative cost of equity versus de bt capital, the tax treatment of funding costs, and the level of interest rates.

Whether credit should be expected to lead or lag activity is unclear. Whether the change in activity is perceived to be temporary or permanent is an important issue. It is possible that an initial upturn or downturn in income may not be treated as permanent. If an initial decrease in income is regarded as temporary, consumers may increase borrowings to maintain consumption until income returns to its expected permanent level. On the other hand, if the fall in income is perceived as permanent, consumers may reduce their borrowings in line with lower expected future income. On this basis, credit may rise initially, then fall later, lagging the movement in income.

In addition to these considerations, a change in the conditions on which credit is extended could affect the demand for credit, particularly for investment purposes, and through that, spending. Here, credit could be a leading, or at least coincident, indicator.

The availability of credit can also be affected by regulation of the credit market. An interest rate ceiling, for example, can effectively impose quantity rationing on bank advances. In such a situation, changes in income may not cause changes in the level of bank advances. Deregulation, such as has occurred in Australian markets in the past decade, may change the relationship between credit and economic activity.

In summary, economic theory does not unambiguously predict whether financial aggregates should lead or lag economic activity. This relationship might also depend on the nature of policy, changing if the implementation of policy changed. For example, an observed leading relationship from financial aggregates to economic activity may break down if authorities attempt to use this regularity to influence activity.[1] Relationships might also break down with structural changes, such as recent financial deregulation.

Of course, “credit” and “money”, seen above as separate indicators, are in reality the bulk of the two sides of the financial system's balance sheet, and so should be integrated into one model.

This study does not attempt such an ambitious project. It does not attempt to grapple with the structure; rather, it simply seeks to show the empirical regularities characterising money, credit and nominal activity.


This criticism of monetary targeting has become known as Goodhart's Law. See Goodhart (1975). [1]